The donation of closely held business interests to charity may be one of the best charitable decisions made. Getting the appropriate tax deduction requires advance planning and a business valuation.
Charitable Gifting of Closely Held Stock and Carried Interests
The donation of closely held business interests to charity may be one of the best charitable decisions made. Getting the appropriate tax deduction requires advance planning and a business valuation. The most logical assets to donate are the lowest tax basis assets. Closely held businesses, inherited property, property with an unknown tax basis, carried interests and other significantly appreciated property are the usual candidates. These donations typically leave a valuation uncertainty putting your charitable contribution tax deduction at risk.
By working with sophisticated charities and carefully following tax laws, there is a more certain method for achieving gifts with a certain outcome. Instead of gifting the equity interest directly, create a new security that has rights to the underlying assets. This new security is a "Option" as the holder has the right to exercise the Option by putting it to the Company or individual for a fixed dollar amount of Assets say $1 million. By defining value in the security agreement we eliminate valuation risk. IRS rules dictate that the charitable deduction is triggered on the date the Option is exercised, and the deduction is the cash received by the charity. Much simpler than a business valuation fight with the IRS.
So how do we get the Option to the Charity? We sell it to the charity for $1.00. However, this sale does not trigger a gift. Now the charity holds this valuable Option and should the underlying asset be sold within a defined timeframe of maybe 1-2 years, the charity will get its $1 million from the buyer. If there is no sale, then the charity will put the option to the donor. So the donor or their kids, grandkids, employees or any other buyer selected could buy the Option, potentially generating a favorable step up in basis.
The timing of the deduction will be dependent on the receipt of cash by the charity, so this method is most appropriate for the donor who could use a deduction in any tax year. However, with careful planning, the sale of a business and receipt of cash by the charity will occur in the same tax year. A business valuation is still required but now instead of supporting the charitable deduction amount, the valuation meets the IRS requirement that such transactions to be valid must have an appraisal.
At exercise, the net cash received by the charity depends on the value of the underlying assets - the Option is only a right to sell something for a defined price – the charity now has the right to purchase $1 million in Company Assets. The charity acquired this right for $1 from the donor who had previously purchased the Company Assets. Value in an Option is generated at exercise by purchasing an asset at a lower market price ($1) and then using the Option to sell it for a contractually defined higher price ($1 million). The contractually defined value must be supported by sufficient assets and equity.
Charities like this Option structure as it avoids UBIT (Unrelated Business Income Tax). Furthermore, it shields the charity from environmental challenges potentially associated with any real property assets.
The Option is a separate security and is separate from any existing transaction negotiations avoiding a deemed sale risk. A deemed sale results in the following undesirable outcome: you have no tax deduction, are liable for the tax related to sale of an asset you gave away, and the charity has the cash.
A buyer needs to understand that the purchase of the business will now be done in two bites. The typical purchase transaction with the price reduced by the Option amount of $1 million, and a second transaction to purchase the Option assets for $1 million. The Option is treated as an assumed liability by the buyer just like debt or accounts payable.
The benefits of making gifts of highly appreciated but complex assets are significant. Structuring this Option transaction correctly is essential to receiving the benefits. Authors David Adams, CPA, ABV, ASA - President of Adams Capital (immediate past president of the Atlanta Estate Planning Council) and Doug Duncan - Partner with Lefko ff Duncan (member of the Atlanta Estate Planning Council) have extensive experience with such matters and look forward to discussing how this gifting strategy may fit your specific circumstances.