If you are a business owner that: (1) is looking towards succession planning and the option of selling your interest in a business; (2) has inclinations towards charitable giving; and (3) is looking to save money on taxes—this strategy may be right for you.
It starts with a desire on the part of the business owner to provide some amount of assets to a charity (with the side benefit of a potential tax deduction).
For an explanation based on an example, let’s turn to Jane. Jane owns an operating business worth $1M. First, how does she know the business is worth $1M? She turns to her CPA or hires a special valuation expert (with associated business valuation credentialing like ASA, NACVA, ABV, or the like). Even though Jane plans to sell the business, a valuation is necessary to substantiate the gift in the scenario outlined below.
Jane has a low tax basis in the business which operates as a C corporation. Her tax basis is $0. I am assuming she would sell her business as a stock sale (versus asset sale). So, if Jane were to sell her business, she would be forced to recognize $1M of taxable gain. This would be taxed at anywhere between 15% to 23.8%. Assuming a 23.8% tax rate, the amount of tax due would be $238,000. This is a significant tax hit.
Jane has agreed to stay on with the company as a consultant for 3 years after the sale and will make 100k a year for her efforts. Her total compensation from the sale and the salary would be $1,300,000 before taking into account the tax hit on either kind of income.
Some background on Jane is helpful, too. Jane loves to give money to charity and gives around $30,000 a year to local charities that qualify as 501(c)(3) charities.
Consider an alternative plan. Instead of a straight stock sale to a buyer, consider that Jane, before the sale of her corporation, gifts 30% of her stock to a Donor Advised Fund (so $300,000 in appreciated stock). A Donor Advised Fund (DAF) is a type of charity (qualifies as a 501(c)(3)) where the donor can leverage the gift over time and direct the gift giving from the DAF to Jane’s favorite local charities. This can be accomplished over as few or as many years as Jane desires.
So, Jane makes the gift of 30% of her stock in the corporation. She then sells (and the DAF agrees to sell) all the stock in the corporation to the buyer. Now, Jane has cash ($700,000) and the DAF has cash ($300,000). The DAF pays no capital gains on its sale of the 30% interest in the company. The DAF keeps the proceeds invested in a portfolio pending distribution. Jane has several tax benefits that result from this transaction. First, she need not recognize the full $1,000,000 of gain. Instead, she would recognize the gain from her portion of the corporation – (70% or $700,000). Second, she gets to take a deduction of $300,000, the full fair market value of her shares donated to the DAF.
Her tax liability changes dramatically. In year one (the year of the sale), assuming she had no other income, she could deduct a portion of the gift. The deduction is limited to 30% of her Adjusted Gross Income (because she gifted appreciated stock). Accordingly, her deduction in the year of sale would be 30% of $700,000 or $210,000. That means she would have about $90,000 of unused deductions ($300,000 – $210,000 used in first year) to use in future years. She can carry the deduction (the remaining $90,000) forward up to five years to offset her income from her continued employment. So, she will be able to completely use up the deduction against her income from continued employment with a deduction of about $30,000 a year.
Of course, many variables affect this simplistic calculation. Your individual tax benefits may vary greatly and it’s worthwhile to always consult a professional tax advisor. The new tax laws enacted for this year have further complicated the planning, but a gift of appreciated stock is still a great option to consider.
* Licensed, not practicing.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.