Giving appreciated stock can have tax benefits
Donor-advised funds strategy can enable multiyear deductionsOctober 26th, 2023
Giving appreciated stock in a company might be the right path for a business owner who is looking toward selling interest in a business with an inclination toward charitable giving and a desire to save money on taxes.
For an explanation based on an example, let’s turn to Jane, who owns an operating business worth $1 million.
First, how does she know the business is worth $1 million? She turns to her CPA or hires a special valuation expert with associated business valuation credentialing, like ABV. Even though Jane plans to sell the business, a valuation is necessary to substantiate the gift in the scenario outlined below.
Jane has a low tax basis in the business, which operates as a C corporation. Her tax basis is $0. Assume she would sell her business as a stock sale rather than as an asset sale. If Jane were to sell her business, she would be forced to recognize a taxable gain of $1 million. This would be taxed at 15% to 23.8%. Assuming a 23.8% tax rate, the amount of tax due would be $238,000. This is a significant tax hit.
Jane has agreed to stay on with the company as a consultant for three years after the sale and will make $100,000 a year for her efforts. Her total compensation from the sale and the salary would be $1.3 million before taking into account the tax hit on either kind of income.
Some background on Jane is helpful, too. Jane loves to give money to charity and gives around $30,000 a year to local charities that qualify as 501(c)(3) charities.
Consider an alternative plan. Instead of a straight stock sale to a buyer, consider that Jane, before the sale of her corporation, gifts 30% of her stock to a donor-advised fund—$300,000 in appreciated stock. A DAF is a type of charity that qualifies as a 501(c)(3) through which the donor can leverage the gift over time and direct the gift giving from the DAF to Jane’s favorite local charities. This can be accomplished over as few or as many years as Jane desires.
So Jane makes the gift of 30% of her stock in the corporation. She then sells—and the DAF agrees to sell—all the stock in the corporation to the buyer. Note the nuance: the agreement to sell by both Jane and the DAF has to happen after the gift is complete.
Once sold, Jane has $700,000 cash, and the DAF has $300,000 cash. The DAF pays no capital gains on its sale of the 30% interest in the company. The DAF keeps the proceeds invested in a portfolio pending distribution. Jane has several tax benefits that result from this transaction.
First, she need not recognize the full $1 million. Instead, she would recognize the gain from her $700,000 portion of the corporation. Second, she gets to take a deduction of $300,000—the full fair-market value of her shares donated to the DAF.
As Jane continues her charitable giving from the DAF, her tax liability changes dramatically. In the year of the sale, assuming she had no other income, she could deduct a portion of the gift. The deduction is limited to 30% of her adjusted gross income because she gifted appreciated stock. Accordingly, her deduction in the year of sale would be 30% of $700,000 or $210,000. That means she would have about $90,000 of unused deductions to use in future years. She can carry the deduction—the remaining $90,000—forward for up to five years to offset her income from her continued employment. So she will be able to completely use up the deduction against her income from continued employment with a deduction of about $30,000 a year.
If she wants to use the deduction faster and potentially more effectively, she can look to convert some of her traditional pre-tax individual retirement accounts to Roth IRAs causing higher income in the year of conversion and thus allowing more of the deductions to be used.
Of course, many variables affect this simplistic calculation, and the strategy has pitfalls to consider before engaging in the transaction. Your individual tax benefits may vary greatly and it’s always worthwhile to consult a professional tax adviser.