Privately held business interests

Case study: maximizing charitable impact while mitigating tax exposure

Sue, an executive at Corporation XYZ, plans to convert a portion of her concentrated XYZ holdings into cash to fund her philanthropic goals. As there is no easily identifiable market for XYZ stock, Sue’s company has a buyback program in place for shares that are donated to charity. 

Sue decides to establish a donor-advised fund account as a way to maximize charitable impact while potentially mitigating capital gains tax exposure. Sue works with the donor-advised fund’s staff to complete the necessary paperwork for the assignment of $1 million shares of XYZ to the donor-advised fund and transfer back to XYZ through its buyback program. The shares have a cost basis of $50,000, and Sue's income level would result in a 20% capital gains tax rate on $950,000 of appreciation if she were to sell the shares or transfer the shares back to XYZ.

In Option 1, if Sue transfers the $1 million of shares to XYZ, pays the estimated $190,000 in federal capital gains taxes ($950,000 x 20% = $190,000), and donates the after-tax proceeds, her tax savings are only $109,700. 

By assigning $1 million of XYZ directly to charity and utilizing the firm’s buyback program, as shown in Option 2, Sue potentially eliminates $190,000 in projected federal capital gains taxes. When combined with her potential income tax deduction, Sue’s tax savings is $370,000. 

Additional considerations 

In addition to the potential tax benefits described above, the following considerations may apply. 

1. Avoid prearranged sales.

If a sale of your privately held business interest is expected, the terms of the sale should still be under negotiation. The documentation and actions must not have proceeded to the point at which the IRS would consider it a prearranged sale. In that unfortunate instance, the IRS may deem your gift an “anticipatory assignment of income” to the charity. As such, you may be required to pay capital gains taxes on the sale by the charity.

2. Business gifts require due diligence by the charity and careful planning by the donor.

Many charities will not accept gifts of privately held business interests due to the complexity involved. Donor-advised funds and other public charities that do accept these gifts likely will do so only after performing substantial due diligence. For example, the company’s governing documents—such as shareholder agreements, operating agreements, bylaws, etc.—must be reviewed to understand whether there are any transfer restrictions or embedded liabilities, and to assess the time and process to complete the charitable transfer.

There can be complexities on the donor side of the gift as well. For example, donations of indebted interests may trigger negative tax consequences for you and the receiving charity, including tax liability. In addition, if you itemize, the deduction for gifts of S-Corp, LP, and LLC interests may be reduced by the amount of ordinary income that would have been realized if you had sold the interest at fair market value on the date contributed.

The above is one example of many possible considerations. Please consult with your tax advisor prior to donating interests in privately held businesses.

3. There are special rules for donations of S-Corp interests to charity.

The donor-advised fund or other public charity will generally be subject to unrelated business income tax (UBIT) on its income from the sale of the S-Corp business. The charity may use the proceeds of the sale to pay these taxes and may escrow a portion of the proceeds in a separate account for three years to match the IRS’s “look-back” period, during which the IRS can challenge the cost basis of the shares and the taxes paid.

4. Qualified appraisal requirements and annual deduction limits apply.

Overall deductions for donations to donor-advised funds are generally limited to 50% of your adjusted gross income (AGI). The limit increases to 60% of AGI for cash gifts, while the limit on donating appreciated non-cash assets held more than one year is 30% of AGI. The IRS permits a carryover for five tax years, should your charitable deduction exceed AGI limits in a given tax year.

For gifts of privately held business interests in excess of $5,000, donors must obtain a qualified appraisal by a qualified appraiser to substantiate fair market value for the charitable deduction. Appraisals must be obtained no earlier than 60 days before the date of donation or no later than the due date of the donor’s tax return (including extensions) for the year of the gift. Appraisals depend on the facts and circumstances at the time of contribution and valuations may be discounted for lack of marketability and/or lack of control.

Interested in learning more? 

• The Charitable Strategies Group at DAFgiving360 is a team of professionals with specialized knowledge about non-cash asset contributions to charities. Our team stands ready to support you and your advisors, from initial consultation through asset evaluation, receipt, processing, and sale. We strive to provide unbiased guidance and frequent communication at every step of the process to help you and your advisors make informed decisions and stay aware of the time required for your transaction. 
• For more information about the advantages of contributing appreciated non-cash assets, you can read an overview article or call us at 800-746-6216. 
• If you would like to learn more about donor-advised fund (DAF) accounts with DAFgiving360, click here.