FRIENDS DON’T LET FRIENDS GIVE CASH
Should your business owner clients give their company stock to charity? In September 2022, that’s what Yvon Chouinard – founder of the Patagonia apparel empire – did with his $3bn ownership interest in the Certified B Corporation. He created a special “Patagonia Purpose Trust” and a new non-profit, “The Holdfast Collective,” to direct the company’s annual profits to protecting the environment. Because of the unique structure used for this transaction, Chouinard and his family received no tax benefits from the arrangement. Noble though this gesture was, no one expects your clients to follow suit. Your clients needn’t pull a “Patagonia” to realize significant philanthropic and financial benefit from giving non-cash assets like S-Corp shares.
I recently caught up with my friend and colleague Michael King to get his views on using S-Corp stock for charitable giving even amidst a slowing economy. King is as informed about non-cash charitable giving strategies as any advisor I know. He serves as a charitable gift and estate planning attorney with the National Christian Foundation (NCF) where his primary focus is facilitating charitable gifts of complex assets such as closely held businesses, real estate, and intellectual property. Highlights of our discussion follow.
Why should high-net-worth clients consider non-cash philanthropic gifts?
There are two primary reasons. First, non-cash assets are where most of the wealth in this country reside. In fact, cash generally represents less than 10% of what people own. The other 90% is comprised of other assets such as marketable securities, real estate, interests in private businesses, etc. As a result, when many families want to make significant charitable gifts or find opportunities to increase their giving, they will often need to look beyond simply their cash holdings to these other assets.
Second, many non-cash assets provide enhanced tax benefits compared to simply giving cash. Appreciated assets in particular—such as marketable securities, real estate and private business interests—often provide double and even triple tax benefits compared to cash gifts. For example, if an individual gifts a publicly traded stock that has substantially appreciated in value (and has been held more than a year), she can give the stock to charity and receive a double tax benefit—a charitable deduction for the value of the stock, and the avoidance of capital gain tax to herself and the charity when the charity sells the stock.
These two factors and their associated benefits often lead to families being able to give significantly more to support their favorite charities and charitable causes. Because of the charitable leverage non-cash gift produce, one of my favorite quips to remind families and advisors of these gift opportunities is that “friends don’t let friends give cash.” Of course, this quip is somewhat in jest, as often the ideal giving strategy involves a combination of cash and non-cash assets in order maximize the amount and impact of a family’s charitable giving.
Why are gifts of S-Corp stock so often overlooked?
Well, I would say gifts of private businesses in general are often overlooked, and perhaps the reason is quite simple, not enough business owners, nor their advisors are aware of the advantages of giving such assets in addition to or in lieu of more traditional cash gifts. In fact, many people have never even thought about the possibility of making a charitable gift of an interest in a private business. Approximately 80% of all charitable giving in the United States is done in the form of cash, so business interest gifts simply aren’t on the radar screen of most individuals or families.
In addition, even for those who are familiar with the opportunity and tax benefits of giving business interest gifts, they may be dissuaded because of the complexity associated with such gifts. The industry often refers to gifts of business interests, real estate, intellectual property, etc. as gifts of complex assets. This reality is part of the reason why it’s essential to have a highly competent advisor or team of advisors familiar with complex assets gifts to ensure such gifts are structured and implemented properly.
With respect to gifts of S corporations, there are some unique issues that can make gifts of S corporations more often overlooked, and/or challenging compared to other types of business entities such as C corporations, LLCs or partnerships. One significant issue is the fact that upon sale of an S corporation by a charity, the capital gain is taxable to the charity in the form of unrelated business taxable income. The capital gain generated to a charity from the sale of a C corporation, LLC or partnership is generally exempt from taxation. There are ways to dramatically mitigate a charity’s tax on the sale of S corporation stock, but the gift transaction needs to be very carefully structured in order to achieve such a result. Often, even the most sophisticated and knowledgeable advisors are not familiar with how to structure such a gift to mitigate such taxes.
Another sometimes challenging issue is that split-interest gifts are often more challenging with S corporations then with other types of business entities. In fact, charitable remainder trusts, for example, are prohibited from owning S corporation stock without blowing the corporation’s subchapter S status and causing the corporation to automatically become a C corporation subject to double taxation. Finally, if an S corporation sale by a charity is structured as an asset or deemed asset sale—in other words the underlying assets of the S corporation are sold as opposed to the stock itself, adverse tax implications can arise that dramatically reduce any tax benefits of making a gift of the S corporation as opposed to simply give cash from the sale proceeds.
Both of these two later issues can be successfully navigated, but very careful planning is required to ensure the tax and charitable benefits are fully realized.
When should clients consider S-Corp stock gifts?
There are two primary situations when S-Corp stock, or any other type of business entity, gifts should be considered. The first is when a business owner has decided to sell his business, and therefore, is facing a significant tax liability, perhaps the largest taxable event of their life. By making a charitable gift of stock prior to a sale, the owner secures a charitable deduction for the value of the gifted interest, and personally avoids capital gain tax on the gifted interest—effectively capturing a double tax benefit. Whe the charity sells its interest, and if the interest is properly structured, the charity will pay a dramatically lower tax liability compared to what the owner would have paid personally—often reducing the associated tax liability by 60% or more.
The other situation or strategy is where there is no sale anticipated in the near term, but the entrepreneur wants to use their business as an engine for generosity. Typically, they'll target the maximum they can deduct on an annual basis. If you give an asset other than cash, the maximum you can deduct each year is 30% of your adjusted gross income (AGI). So, a lot of these families will carve off small ownership pieces of their business as a gift targeting 30% of their AGI. For many business owners, a gift of 2% to 4% of the fair market value of their business will enable them to maximize the allowable 30% of AGI deduction. In addition, to other cash giving they may already be doing, some families will take all or a portion of the tax savings generated from the charitable deduction of the business interest gift, and make an additional cash gift. It’s not unusual for families to maximize their total charitable deductions—50% of their AGI—using this strategy.
The charity that receives the business interest gift will simply hold its ownership interest until such time that a liquidity event occurs. In the meantime, the charity will receive a pro-rata portion of any taxable income and distributions made by the business—if the business is a flow-through entity such as an S corporation, LLC or partnership—and any dividend distributions made by a C corporation.
This “engine for generosity” strategy effectively captures a triple tax benefit. The business owner receives an immediate charitable income tax deduction, the charity pays a reduced effective tax rate on the charity’s share of annual operating income, and upon an eventual sale of the gifted interest, the charity pays a reduced capital gain tax (and in some cases avoids capital gain tax completely).
What Nuances Need to be Navigated?
I mentioned earlier some of the unique issues that apply to S corporations, but not other business entities. There are often subtle, but sometimes very important differences in the tax implications and issues that arise depending on the nature of the business entity being considered for a charitable gift of interests in private businesses. For example, unrelated business taxable income applies to S corporations, LLCs and partnerships, but not C corporations (though C corporations are subject to a corporate level tax even for stock owned by charity).
If a charity plans to hold an interest in certain private businesses longer than five years, an excise tax referred to as “excess business holdings” may come into play and require proper planning to avoid the imposition of such tax.
Another issue that comes into play when a charity receives a gift in close proximity to a sale of the business is a tax doctrine referred to as “anticipatory assignment of income” and/or “prearranged sale” which requires the charitable gift to be fully consummated prior to the giver entering into a legally binding sale.
The nature of the legal structure and entity that receives the charitable gift is also very important with the tax and charitable benefits varying significantly depending on the specific type of charitable organization receiving the gift. For example, it is generally inappropriate for a private foundation to receive gifts of private business interests as the corresponding charitable deduction is limited to the lesser of fair market value and basis. The most common charitable entity/organization to receive such gifts are a small group of donor advised fund sponsors, including some very experienced community foundations. A handful of these organizations have attorneys and CPAs on staff with deep experience and expertise in facilitating gifts of this nature, and because these organizations have public charity status, they are able to provide a full fair market value deduction.
Finally, it is often beneficial for the charitable recipient of such gifts to be structured as a trust entity under state law, as opposed to a charitable corporation as any tax liability that may arise with respect to the charity can generally be mitigated to the greatest possible extent.
What about the economy?
Despite increasing concerns and anxiety of the general economy, we haven’t seen a significant reduction in charitable giving, at least not yet. Gifts of marketable securities will most certainly be down from last year, but it’s helpful to remember that there are still a lot of people with highly appreciated marketable securities available for giving. Even if those people just lost 20% of the value of their marketable securities portfolios, they may nonetheless have some stocks with a very low that continue to provide leveraged giving opportunities over cash.
With respect to the private equity world and privately owned businesses, there has been a noticeable slowdown in merger and acquisition activity and transactions. The dramatic increase in interest rates has resulted in a correspondingly dramatic increase in the cost of borrowing to acquire businesses. Having said that, there remain some private equity firms and investors with substantial cash looking to be deployed that may not require significant debt to acquire.
Even with the slowdown in mergers and acquisitions, the “engine for generosity” strategy that enables families to maximize their charitable giving remains a strong and viable strategy for those looking to reduce their overall tax liability and continue to give generously.
What Should Advisors Do?
Generous families and business owners will continue to look for advice and strategies that enable them to maximize their charitable giving and minimize their tax liability. In fact, during economically challenging times, such advice and counsel often becomes even more important and impactful. Advisors should equip themselves with the tools and resources to uncover financial, estate, charitable, tax and business succession opportunities, and deliver creative, high-value strategies that enable their clients to prosper in good and challenging economic times.
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