Business owners who work hard to grow a business and sell it (hopefully, with a substantial windfall) oftentimes focus on philanthropy and making a difference with their new-found wealth. Successful sellers usually recognize significant amounts of taxable income in the year of sale. For those charitably inclined, there are a number of options for making charitable contributions while also maximizing tax benefits. In some cases, it is important that the client act in the year of the liquidity event.
In evaluating the planning options, a client should first identify and prioritize his or her objectives. If a charitably-inclined client has a significant liquidity event, he/she will want to engage in charitable giving in the current year to decrease income tax liability from the event. The client may also want to make additional gifts to children or other descendants while managing the estate tax burden, or to retain access to the sale proceeds for their own non-charitable uses. Mixing a charitable inclination with these goals can be very beneficial for tax planning.
Charitable Income Tax Deduction and Limitations
Before reviewing complex gift techniques, planning begins first with considering whether the client can make a gift of the business interest to charity before the sale or liquidity event. This can generate significant tax savings. If structured correctly, the donor can receive a charitable income tax deduction for the fair market value of the business interest contributed to charity and also avoid the income tax on the subsequent recognition event.
In many cases, making a gift to a charity before the sale may not be workable given the structure of the business or the sale process. If the client decides he or she cannot contribute a portion of the business to charity before the sale, the client should focus on the limitations of the charitable income tax deduction on gift timing. The key focus is whether the client should spread out his/her charitable income tax deduction over time or whether the client should focus on obtaining a charitable deduction in the year of the liquidity event. Spreading charitable contributions over time means the client is more likely to be able to use a charitable income tax deduction against ordinary income (given that even with low interest rates, an individual is likely to have some ordinary income each year).
The value of an income tax deduction depends on the type of income it offsets. The charitable income tax deduction generates a savings based on a function of the client’s top marginal rate. In 2021, long term capital gains are taxed at a rate of 20%, and the highest marginal rate for ordinary income is 37%. Thus, any tax deduction reducing ordinary income and long term capital gains will generally save 37 cents and 20 cents on the dollar, respectively (plus state tax, if applicable). If the taxpayer has both ordinary income taxed at a higher rate and long-term capital gain taxed at a lower rate, the charitable income deduction will offset higher ordinary rate income first until all of the higher ordinary rate income is exhausted; then it will offset higher capital gain.
Typically, the client’s income from a business sale will be long-term capital gain. The client is also likely to have ordinary income in the year of sale (perhaps bond interest, rent, short-term capital gain income, or even consulting or other types of income). It is preferable to use the charitable income tax deduction against these types of income—and it may be beneficial to at least delay some charitable giving so that it can be made in the future and offset this ordinary income.
However, if a client wants to dedicate a significant portion of his or her assets to charity (and is willing to make the gift during lifetime), deferring the gift could result in the adjusted gross income (“AGI”) limitation disallowing the charitable deduction in those future years when income is lower.
While a client may donate all of his or her assets to charity, the charitable income tax deduction permitted the client is not unlimited. The federal income tax code’s deductibility rules limit the amount a client can charitably deduct in a given year based on his/her AGI.
- Gifts of cash to a public charity or a donor advised fund are generally limited to 60% of AGI. However, the recent CARES Act increased this limitation for donations directly to public charities to 100% of AGI for 2020.This limitation was recently extended for the calendar year 2021.1 It does not extend to donor advised funds or supporting organizations.
- Gifts of cash to a private foundation are limited to 30% of AGI.
- A donor can also make a gift of appreciated property, such as appreciated public securities. In many cases, he/she will receive a deduction equal to fair market value and also avoid the income tax recognition on the gain. However, this also means that the AGI limits are lowered: the AGI limit is 30% for gifts of appreciated property to a public charity, and 20% for gifts of appreciated property to a private foundation.
- To the extent a client has a charitable deduction in excess of the applicable AGI limitation, the amount can be carried forward for five years. It cannot be carried backward to offset income in prior years.
- If the client dies with an unused charitable income tax deduction, it is lost forever.
AGI is volatile for most business owners over time, especially in the year of sale. In the tax year of the liquidity event, the client will have a significant AGI (albeit mostly capital gain). The client will likely have a much lower AGI for the remainder of his/her lifetime, especially the client who is permanently leaving the workforce and will invest the sale proceeds in stocks and bonds (both of which may only provide limited amounts of income). If the client delays the charitable giving to a future year, the client may not be able to use the entire deduction—the client’s AGI will never again be high enough to fully claim the deduction. In addition, by accelerating the deduction, the client receives the tax break today and can immediately invest the current year tax savings. The client and the planner will need to forecast tax results based on the client’s life expectancy, size of gift, and amount of income.
Delaying Charitable Gifts
Having decided on the best timing for a gift, the client must select a method of giving. The simplest option is to make a direct gift to a public charity—a 501(c)(3) organization, such as the Red Cross, a university, or a hospital (a “public charity” generally receives contributions from many donors and is not controlled by the client). The client makes the gift and the recipient organization uses it for the purposes required by the client, if any; perhaps a larger gift could be used for a permanent endowment or capital project.
For some clients, the optimum income tax planning (making a large gift in the year of the liquidity event) does not necessarily correspond with his/her vision of philanthropy. The client may wish to investigate and learn more about the organizations that he or she wishes to support. The client may want to build a relationship with an organization before making a large irrevocable gift. The client may also wish to involve family members with gifting as a way to transfer values to younger generations. In some cases, the client will want his/her funds to be set aside permanently or long-term so that the family can choose to support charities in the future. This philanthropic intent is at odds with income tax planning that requires a quick contribution in the year (or months) after a liquidity event.
Fortunately, these clients can achieve both an immediate income tax deduction and a deferment of gifts over time. These clients can make a gift to a family foundation (a section 501(c)(3) organization that is usually considered a “private foundation” and controlled by the donor and his/her family) or to a donor advised fund (a section 501(c)(3) organization that holds the assets in a separate account and allows the donor and his/her family to provide recommendations for how to invest and make grants from the funds). These charitable vehicles allow the client to disburse the contribution to charitable organizations over time. The client maintains a certain level of control over the funds held in these vehicles. The client can involve his/her family in philanthropy by permitting them to make decisions about distributions or grants to specific charitable organizations. As an added bonus, the funds held by the private foundation or donor advised fund can be invested to grow tax-free over time, generating additional funds for grants to charitable beneficiaries over the long term.
Although these entities serve the same purpose, there are key differences impacting the client’s income tax deduction.2 Like a direct contribution to a charitable organization, the contribution to the private foundation or donor advised fund is deductible in the year of contribution (subject to the AGI limits).
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The second installment of this Article will discuss strategies for mixing charitable gifts with gifts to family members or retaining assets to maintain the client’s lifestyle.
1 For more information on the AGI limitations and changes to the charitable income tax deduction made by the CARES Act, see CARES Act Changes to the Charitable Income Tax Deduction.
2 For a detailed analysis of the differences in making charitable contributions to donor advised funds versus private foundations, please see https://www.foley.com/en/insights/publications/2020/11/comparison-private-foundation-donor-advised-fund.