Picture it: Two founders are golfing. One proudly tells the other about their recent business exit and big financial windfall—but laments the major tax hit. The second golfer asks: “Well, did you make a charitable donation before you sold the company?” And then they explain how they did donate private stock before their own company exit—and the subsequent tax benefits and philanthropic impact. The aggrieved first golfer gets quiet. Their next phone call? To their financial advisor: “Why didn’t you tell me about this option?”
Who would you rather be: the financial advisor or attorney who had already explained a tax-smart strategy for donating private stock to their client? Or the one whose client called them wondering why they missed an opportunity? It’s not uncommon for successful entrepreneurs to have significant portions of their wealth tied to these kinds of illiquid assets. Such assets—also called complex assets—can include private company stock, restricted stock, real estate, and more. These can be challenging to transfer or donate to charity, and when sold, they can induce significant taxes. But consider the opportunity presented by changes in the broader market. The number of public companies have declined by almost half over the past two decades. And, when looking at companies with revenues greater than $100 million, there are now only 2,800 public firms vs. 18,000 private firms. Regardless of their size, with a greater prevalence of private companies, there’s a growing need for founders to understand how they can give smarter when it comes to assets connected to their private businesses.
Fortunately, there are effective ways to donate complex assets, and there’s good indication that entrepreneurs are primed to do so. Research shows that 91% of high-net-worth investors say that a charitable strategy is part of their overall wealth strategy, but many could be giving smarter. Exit-ready founders often fall into this category. In fact, research indicates that 69% of entrepreneurs who plan to sell their businesses want to incorporate charitable giving into their exit plans. Here are three tips that financial advisors and attorneys—and their entrepreneur clients—can use to make illiquid assets an effective part of their philanthropic strategies.
1. Reap tax advantages—and greater giving potential—during a wealth-triggering event
When entrepreneurs start eyeing private business exits, public M&As, or pre-IPOs, it’s an ideal time to consider donating complex assets to charity. The potential tax benefits can be significant: a charitable deduction of the asset’s fair market value (if the entrepreneur owned the asset for over a year) and elimination of capital gains taxes that would be due if the asset was sold rather than donated.
Entrepreneurs who anticipate wealth-triggering events can donate different complex assets—private stock (C Corp., S Corp., partnership), restricted stock, LLC and limited partnership interests, or real estate. It’s critical to secure an independent, third-party appraisal of the donated asset to substantiate the charitable tax deduction. The tax benefits and transactional considerations vary based on the asset type, so it’s important to understand the implications of each.
There are several avenues for donating illiquid assets, but donating them directly to the end-designated charity may prove cumbersome as many nonprofits don’t have the resources or internal expertise to accept these kinds of assets directly. This may result in the entrepreneur selling the asset and donating the proceeds to charity. As a result, they’ll owe capital gains taxes, diminishing their potential income tax deduction and reducing the dollars available for charity. So, it is often more tax-efficient and results in more funds to benefit charity to consider other avenues: donating complex assets via charitable lead and remainder trusts, public charities that administer a donor-advised fund (DAF) program, or private foundations. Each has its own advantages and limitations, so choose wisely. For example, if you donate an appreciated asset to a public charity that administers a DAF program, the tax deduction is taken on the asset’s fair market value (remember to allow time for a third-party qualified appraisal). If you go the private foundation route, the tax deduction may be limited to the cost basis or fair market value, depending on the asset type.
It’s rarely optimal for founders to wait until after business exits to open their checkbooks to charity. By then, it’s capital gains tax time. An entrepreneur who plans to sell their business, for example, could instead donate a portion of their ownership interest before the sale, claim a charitable tax deduction for the value of donated interest, and minimize capital gains exposure. Be cognizant of timing. Generally, if someone makes a contribution after all the material terms of the sale are agreed upon and there is no material risk that the sale will not close, the IRS may conclude on audit that the contribution is an “anticipatory assignment of income.” This means that the IRS could require the individual to pay any capital gains tax that they would have otherwise owed upon selling those shares.
2. Build complex assets into tax-savvy estate and legacy plans
Middle-aged founders—a group that’s primed to contemplate estate and legacy planning—are twice as likely to achieve successful exits as younger entrepreneurs. As these seasoned entrepreneurs prepare for potentially the greatest wealth-triggering events of their lifetimes, they should explore wealth management, legacy and estate planning, and philanthropic strategies cohesively. Complex assets can be important pieces of this puzzle.
For example, an entrepreneur who makes a planned gift of private stock to charity via their estate plan can establish a charitable legacy, while potentially reducing estate taxes. Entrepreneurs can name charities in their estate plans and specify the type of complex asset they wish to donate. Because there is generally an unlimited deduction of charitable bequests against the value of an estate, this can be an effective way to minimize estate tax. It’s also an excellent way for founders to continue supporting causes they care about after passing away. Be aware that some charities may need to conduct due diligence prior to asset acceptance and that they may need to consider a path to liquidity.
3. Adopt the entrepreneurial mindset: Think ahead on complex assets
Clients want advisors to be strategic, going beyond managing assets to proactively recommending tax-smart strategies for their overall wealth portfolios. This expectation is strong for entrepreneurs, whose unique mindsets influence their perspectives on philanthropy and investments. Entrepreneurs thrive by looking ahead, innovating, and identifying early opportunities. They value advisors who do the same.
Having early conversations with clients about how to incorporate illiquid assets into their wider wealth management and philanthropic plans is a great opportunity to demonstrate differentiating value. Remember, if you’re an advisor or attorney who isn’t talking to clients about donating complex assets, someone else would be delighted to. And that someone might not only be their buddy on the golf course.
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By Karla D’Alleva Vallas, Contributor at Forbes
Published May 30, 2023