As charitably minded business owners contemplate the sale of their businesses, many ask if it makes sense to transfer a portion of the business to charity prior to a sale. In many cases, the answer is yes, but it’s a complex process that must be approached thoughtfully and strategically well before a sale.
Why a Donor-Advised Fund is Often the Way to Go
Most charitable organizations are not equipped, or even allowed by internal policies, to receive direct gifts of private business interests. Why? Primarily because most nonprofits exist to serve their mission, and owning and potentially operating a for-profit business, and the risks associated with that, is not in their best interests. There are a handful of very large, sophisticated organizations that will accept these gifts directly. For example, The Nature Conservancy and Harvard accept these gifts and have in-house legal teams to manage it all. However, they are the exceptions, so making this type of gift directly to a mission-based nonprofit is rare.
That being the case, many business owners will ask if a private foundation can be used as the recipient. There are typically two tax drawbacks to using a private foundation. First, when gifting appreciated assets to a private foundation, the donor’s tax deduction of the fair market value of the asset is limited to 20% of adjusted gross income (compared to 30% when given to a public charity). Perhaps even more challenging, the donor can only deduct the fair market value (versus the cost basis) if the stock is a qualified appreciated security, meaning they are traded on a public exchange. Obviously, private company stock is not qualified, severely limiting the use of private foundations for such gifts.
Donor-advised funds (DAFs) are much easier to establish, operate and manage than a private foundation. Therefore a DAF, sponsored by a public charity, is often the best recipient for gifts of private business interests. DAFs are normally sponsored by a community foundation or by one of the main custodians (e.g. Schwab or Fidelity).
How to Choose the Right DAF
Whether a DAF sponsor charity is a community foundation or a financial firm, be sure to compare them because there are many differences:
• How often do they receive gifts of business interests, and do they have in-house expertise?
• How thorough is the process to accept these gifts?
• How much will their due diligence cost?
• What post-gift services do they offer, and what does that cost?
• Is the charity structured as a trust or a corporation, as this will impact the tax rate on Unrelated Business Income Tax (UBIT)?
• Is rollover equity to the owner expected as part of the terms of sale? If so, will the DAF accept that?
Determining When and How to Gift Business Interests
Transferring a portion of a private business can involve many steps, and each situation, like each business, is unique. Starting this process as far in advance of a sale as possible is imperative. Ordinarily, the process begins when there is a letter of intent (LOI) from a buyer. The due diligence period (typically 90 days) after the LOI is received is usually sufficient to complete all necessary tasks involved with a transfer of business interests. If a business owner is planning to sell at some point in the near future, starting the process before an LOI is received should be considered.
Most of the time, determining the business asset to be gifted is straight forward, but it can be more difficult than it sounds if there are layers of ownership or complicated business structures.
For example, under current tax law, an LLC can elect to be taxed as an S corporation, partnership or C corporation. Since the tax status of an entity is a relevant factor in calculating the benefits of these types of gifts, it is important to know the election made by the LLC. As mentioned earlier, an S corporation must pay UBIT on the gain when sold. An LLC taxed as an S corporation would also bear this disadvantage.
Finalizing the Transfer of Business Interests to a DAF
DAFs generally don’t want to hold private business interests for very long, so starting the process early is important. A best practice is to complete all the due diligence as soon as possible but wait to actually transfer the shares or interests of the business. However, don’t wait too long or the transfer could be ignored by the IRS and be treated as if the donation was made after the sale. Work closely with your advisors on the timing.
Additionally, compare the benefit of making the transfer before the sale of the company, versus gifting cash after the sale. If it’s determined that a gift before the sale is best, determine the optimal amount, considering the 30% of AGI limitation, 5-year carry over for charitable contributions, and any need for cash.
Finally, the IRS allows a charitable contribution for the fair market value of the transferred business interest, assuming the gift is more than $5,000, an appraisal is performed within two months of the gift, or before the tax return is filed for the year of the gift.
To further explore how to transfer a portion of your business interests to charity, please contact Angela Neumann, CFP®, CAP®, MSFS, Senior Vice President, Advisor Group Lead for Sequoia Financial Group.
Investment advisory services offered by Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.
This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Diversification cannot assure profit or guarantee against loss. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses. Sequoia Financial Advisors, LLC makes no representations or warranties with respect to the accuracy, reliability, or utility of information obtained from third-parties. Certain assumptions may have been made by these sources in compiling such information, and changes to assumptions may have material impact on the information presented in these materials. Sequoia Financial Advisors, LLC does not provide tax or legal advice. Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, and CERTIFIED FINANCIAL PLANNER™ in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.