Excerpt from Chapter 7: Gifts of Closely Held Stock

PRE-ORDER YOUR COPY OF “TURNING WEALTH INTO WHAT MATTERS: A PRACTICAL, STEP BY STEP GUIDE TO NON-CASH GIFTS”

Chapter 7:Gifts of Closely Held Stock

In Chapter 2 we went through Publicly-Traded Stock, Mutual Funds, and ETFs. Now it’s time to look at Closely-Held Stock. It’s very important to understand the difference. Publicly-Traded Securities are traded on a public market like the New York Stock Exchange, Shenzhen Stock Exchange of China, and the Toronto Stock Exchange of Canada. Most countries have a public stock exchange. Virtually anyone can purchase stock available at these exchanges.?

Closely-Held Stock is not traded on an exchange. It is owned by an exclusive list of people - often members of just one family. These companies are referred to as “private” or “closely-held”, because their bylaws restrict ownership to a set group of people. These companies are often smaller than public stock companies, but not always. Sometimes they are massive global enterprises.?

Shareholders of these companies sometimes donate shares of their “private” companies to charity. That’s an exciting thing!

Entrepreneurs are the most generous segment of American society.?A study by Fidelity Charitable[1]?outlines several ways they outpace their non-entrepreneur peers when it comes to philanthropy.

·Entrepreneurs give 50% more to charity than non-entrepreneurs.

·Nearly twice as many consider giving a?“very high financial priority”.

·69% say they want to incorporate charitable giving into their exit plans.

Let’s apply our 5-Step process to Closely-Held Stock to discover the opportunities it brings and how it differs from a gift of Public Securities. At the end of this chapter, you will find?Sample Procedures?and a?Closely-Held Stock Gift Questionnaire. These documents are meant to help you get started. You will definitely want to edit them to meet your organization’s specific needs.?

1.????Know the Basics

2.????Ask for the Right Information

3.????Evaluate for Opportunity and Risk

4.???Accept or Decline Respectfully

5.????Manage or Liquidate

STEP 1: KNOW THE BASICS

Thankfully, many of the tax rules for Closely-Held Stock are pretty much identical when it comes to donations to charity. Closely-Held Stock is a capital asset and it comes with the same favorable tax treatment as other capital assets like real estate and public stock. Let’s review.?

When you give a capital asset like Closely-Held Stock, the income tax deduction is based on the fair market value of the shares on the day of the gift, regardless of what you paid for it (as long as it's been owned for at least a year and a day). Simply put, if you paid $5.00 for a share of stock 10 years ago and today it's worth $25.00, your deduction for a gift of that share of stock would be $25.00. That's basically $20.00 of deduction for FREE!?Additionally, you avoid recognition of the capital gain when the gift is made. That means you don’t have to pay capital gains tax like you would if you sold the stock. When it comes to charitable deductions, not all assets receive this special treatment.?

Only long-term capital assets qualify for this exceptional double benefit.?

If you sell the stock and donate the cash, you don’t avoid the capital gains tax. Sure, you would be entitled to a charitable income tax deduction for the cash gift, but that extra capital gains income can cause a ripple effect in your tax picture. For example, extra income can increase the tax paid on Social Security income or increase Medicare premiums. Charitable deductions don’t have any effect on those increases.?In the end, it’s much more efficient to give the stock itself.?

The donor will need to acquire a?Qualified Appraisal?of the shares to determine the value for charitable deduction purposes.?Qualified Appraisals?require specific elements and are outlined in IRS Publications 526 and 561. Publicly-Traded Stock does not require an appraisal, because the value is easy to determine. The shares trade frequently on an open market and so the value is more easily calculated. Closely-Held Stock does not sell frequently; therefore, the rules require an appraisal to determine their value. These appraisals can be quite expensive - sometimes up to 1-2% of the value of the whole business. The appraisal cost is sometimes cost-prohibitive, and the donor may decide to sell the business and make a cash gift from the proceeds instead. It’s smart for them to consider both options to determine the best choice for their situation.

The appraiser is likely to apply a “discount” to the value of the shares. There are two primary types of discounts that they may apply. First, is the?lack of marketability discount. Since there is a small number of people who are permitted to own the stock, the market for sale is limited. Therefore, the value of the stock can be reduced for appraisal purposes. The second type is a?minority discount. If the shareholder owns a minority ownership share, she won’t have as much power over the decisions being made by the company. Her shares aren’t worth quite as much as someone who owns a?majority?share, because that majority owner will have more power. Votes of the majority owner carry more weight. The more shares you own, the more power your votes have. That’s the simple math behind shareholder voting.?

Gifts of Closely-Held Stock tend to come at a specific time in a person’s life.?At some point they will want to exit the business. Most people who own Closely-Held Stock work for the company. It’s often been their life’s work to build and grow the company, but at some point they’ll be ready to retire. They may wish to sell the business to a new owner OR give/sell it to heirs. This time of transition is most often when they will consider donating shares of the business to charity. This is one of the “life events” we looked at in Chapter 1.?

The sale of their business will probably be the biggest “taxable event” of their lives. When they sell the stock or underlying assets of the business, they will probably recognize a LOT of taxable income. As I always say,?

“Taxes don’t define the WHY of the gift, but they very often determine the WHEN of the gift.”?

This large taxable event will be their opportunity to give more to charity than they ever thought possible. Furthermore, donating the Closely-Held Stock to charity prior to a business sale may offer them significant tax savings - as opposed to selling the business and then donating cash.?

These business transition plans often take years to plan. That’s why it’s very important to start the giving conversation early on in your relationship with a business owner. If the transition plan is designed without any consideration given to charitable giving, it can quickly become too late to add that charitable component back in. Business owners don’t automatically think of donating stock to charity prior to exiting the business and neither do their advisors.?It’s our job as fundraisers to plant that seed early so the option can at least be considered. The donor deserves to know all their options going into the planning process.?

Closely-Held Stock comes in a variety of forms.?We’re going to look at the four most common types you’re likely to encounter (C Corps, S Corps, Limited Liability Companies, and Partnerships) and analyze each one within Steps 2-5.?

Regardless of which type you’re dealing with, there are always some basic questions to consider at the outset.?

• ?????What does the donor own?
• ?????What can the donor give?
• ?????What liability comes with the shares?
• ?????What risk comes with the shares?
• ?????What is the charity’s exit plan?

What does the donor own?

In many cases I’ve dealt with, the donor wishes to donate an asset of the company, such as a piece of real estate. If she is the sole owner of the business, she may consider herself the owner of the business assets as well. That isn’t the case. She owns shares in the business. The business owns the assets. It’s important to remember that if the business assets (like real estate, machinery, inventory) are donated, the business will be the donor - not the individual. That can make a significant difference in the financial benefit of the gift to the donor. Sometimes it’s the best choice for the donor, but details of both options (gift of stock vs. gift of assets) should be thoroughly examined by her advisors.?

You should take caution if the company wishes to donate “all or substantially all” of its assets to charity. That could be treated as an asset liquidation by the IRS and the company could be forced to recognize income on the value of the assets even though it was the charity that ultimately sold them. “All or substantially all” is a vague term, but that is the standard used. Be wary of any situation where a Closely-Held company wishes to donate a substantial amount of its assets to charity?and?make sure you encourage the donor to receive experienced legal and tax advice before proceeding.?

What can the donor give?

Many Closely-Held Businesses adopt “Buy-Sell Agreements” or “Cross-Purchase Agreements”. These documents outline who can own shares of the business and under what circumstances shares can or must be sold. That’s how they keep the shares from being sold to anyone outside the pre-established group. Most agreements that I’ve encountered don’t specifically allow for a charity to be a shareholder. If that’s the case, the company will probably need to amend the buy-sell/cross-purchase agreement to allow for donations of shares to charity. To do that, the shareholders will have to agree to make that change. If the donor is the only owner, it should be pretty easy to make that change.?

What liability comes with the shares?

Depending on the way the business is incorporated, shares given to charity come with different levels of risk (legal, financial, etc.). We will take a look at the different risks that come with C Corps, S Corps, and Limited Liability Companies, and Partnerships in Step 3.?

There is an important liability situation to be aware of when it comes to income tax imposed upon charities that own closely-held stock. It’s called “Unrelated Business Taxable Income” (UBTI). When charities own part or all of a business that is?unrelated?to its mission, the charity can be subject to UBTI and the rate is quite high. It’s equal the highest corporate tax rate - whatever that happens to be at the time. There is a reason behind UBTI. Congress doesn’t want charities operating commercial businesses and avoiding income tax due to their tax-exempt status. It would give them an unfair advantage over for-profit businesses. Charities can operate income tax-exempt businesses that further their mission. A good example is a charity that works to help people in third world countries earn a living wage operating a “fair trade” farm and selling the produce.

It is worth noting that a charity organized as a trust, rather than a corporation, may not be subject to UBTI. That is a very advanced area of charitable tax law, and we won’t discuss it in detail in this book.??

What is the charity’s exit plan?

The vast majority of charities do not want to be a long-term shareholder of a Closely-Held Business. They want to liquidate the shares as soon as possible after receiving them and apply the sales proceeds to their mission. Since the shares aren’t sold on a public exchange and can only be owned by a set number of individuals, the market for sale is limited. There may not be an interested buyer for the shares at any given time. Therefore, the charity needs to assess the marketability of the shares prior to accepting the gift. We will look at this in more detail in Step 2.?

STEP 2: ASK FOR THE RIGHT INFORMATION…..

STEP 3: EVALUATE FOR OPPORTUNITY AND RISK…..

STEP 4: ACCEPT OR DECLINE RESPECTFULLY…..

STEP 5: MANAGE OR LIQUIDATE…..

PRE-ORDER YOUR COPY OF “TURNING WEALTH INTO WHAT MATTERS: A PRACTICAL, STEP BY STEP GUIDE TO NON-CASH GIFTS”

[1]?Entrepreneurs as Philanthropists: Understanding Entrepreneurs’ Unique Approach to Giving, Fidelity Charitable, 2018.?