The following is adapted from The Entrepreneur’s Guide to Financial Well-Being.
Many entrepreneurs have an inclination toward philanthropy. They feel they’ve worked hard, received much, and have a responsibility to give back. They usually involve their companies in community events, encourage employees to get involved in charitable organizations, and sit on nonprofit boards themselves. Global entrepreneurs like Bill Gates and Warren Buffett have set up a giving pledge that 168 billionaires have signed, formally promising to give away at least half of their wealth to philanthropic causes.
For many entrepreneurs, however, the topic of charitable gifting only pops up at the end of the year, rather than as part of a strategic wealth management and protection plan.
An excellent financial adviser will make visible the ways to maximize charitable gifting’s potential so your decisions can be more proactive. Sometimes all it takes is asking the question: Would you rather your money go to the federal government or to charities?
Let’s a look at the story of John and Yvonne, who had a $420,000 decision to make when it came to their charitable giving. How did we help them approach it?
John and Yvonne’s Tax Situation
John and Yvonne built one of the first solar installation companies in their state. They worked night and day for years to make it successful. As their third decade in business approached, they had the opportunity to merge with a large publicly held global services firm, in effect selling their company. They planned to retire after the deal was done.
They had been working with us for many years, and, in December, they came to me to finalize their plans and discuss what to do with the proceeds.
During their initial discussions with us, John and Yvonne had noted that they wanted to make a difference during retirement. Their dream was to drive their Airstream around the United States and volunteer at different stops. They wanted to live comfortably, not extravagantly, give back, and pass some of their assets and savings to their two sons.
They wanted to be free from the financial strain they had experienced while building their business and ensure they could support themselves for the rest of their lives. Yet John and Yvonne were uncertain if they had enough money to retire well.
When they merged their company with the publicly held one, John and Yvonne received 50,000 shares of the acquiring company’s stock, in exchange for their shares in their company stock. The value of the acquiring stock had a price of $60 a share.
The total value of exchanged stock was $3 million, and John and Yvonne had an extremely low cost basis in their company stock. Cost basis is the original value or purchase price of the stock for tax purposes, which is used to determine the capital gain, the difference between the stock’s purchase price and its current market value.
In addition, John and Yvonne received $400,000 in combined wages plus $1 million worth of stock options in the acquiring company. The wages and options would be taxed as ordinary income. The couple expected that, given their income situation post-sale, they would be in the highest federal and state tax brackets. We calculated they would owe $518,349 in taxes, something they wanted to minimize.
John and Yvonne had saved well over the years. Their savings had been prudently diversified in their remaining portfolio. After analyzing their situation, we determined they had enough to retire on comfortably, regardless of the value of the new shares of stock.
Charitable Giving as a Way to Offset the Tax Bill
We began looking at their interest in charitable gifting as a way to reduce the risk of the future value of the options and to offset their tax bill. We devised a plan to gift 7,119 shares of stock they received in exchange for the acquiring company’s stock. Their transferred cost basis in the new stock was $1 a share—anything above the basis is taxed at capital gains rates. Hence, 7,119 at $59 a share generated roughly $420,000 in charitable deductions, enough to partially offset the income the stock options generated.
To sum up: the couple had the opportunity to partially offset the $1 million in options by gifting $420,000 in stock, and through additional planning, save $146,520 in taxes.
John and Yvonne chose to lower their tax bill and benefit their community at the same time. They contributed $420,000 to a donor-advised fund, the philanthropic vehicle that allows donors to make a charitable contribution and receive immediate tax benefits.
John and Yvonne needed time to decide which charities would receive the money, and the donor-advised fund permitted them to count the contribution on their taxes and still wait to take the time to decide how to gift the money.
With donor-advised funds, many are set up by investment companies to sell their own products, with investments limited to high-cost underlying funds. Other donor-advised funds provide open platforms where the adviser can select the investments.
That is the kind John and Yvonne chose, resulting in the creation of an endowment of sorts. It wasn’t technically an endowment, but the money would continue to grow during their retirement years. John and Yvonne planned to involve their boys in selecting charities, turning the fund into something akin to a family foundation, one that would teach their sons about the power of philanthropy.
More Ways to Mitigate Taxes
John and Yvonne’s strategy is an example of using a one-time earning event and/or stock option gain to offset a tax impact. Another sound strategy is to manage your tax brackets by making periodic gifts over multiple years.
For example, Jim and Layla are married and make $315,000, which puts them in the 24% federal tax bracket. But this year, Layla received a bonus, making their taxable income $330,000, which puts them in the 32% tax bracket. They gifted $15,000 to a donor-advised fund and dropped to the 24% tax bracket, saving $4,800 in federal tax.
Again, such a strategy is definitely for those with a charitable mindset. Jim and Layla normally gave $10,000 a year to worthy causes. But when Layla received the bonus, they decided they would rather just give the $15,000 to charity.
If they had not, they would have paid the $4,800 and had roughly $10,000 to give anyway. The couple plans to keep using this strategy when it’s appropriate.
Looking at another strategy, many times entrepreneurs invest early in tech stocks that end up in merger situations. With a merger, there is an exchange of stock, and depending on the terms, cash may be distributed to the shareholder as well.
In tax terms, the cash is called “boot,” and it is taxed as ordinary income. Often, entrepreneurs gift a portion of boot to charity by donating shares of stock associated with boot, especially if they are already in a high tax bracket.
Many entrepreneurs, unfortunately, do things the way they did when they worked for a corporation: give with after-tax dollars. Maybe they give 10% of their paycheck a week to their church, temple, synagogue, or mosque. But they could do so much more by planning strategically and giving with pretax dollars.
With a gift of appreciated stock to pay for a religious organization’s membership dues, you don’t pay tax on any capital gains, and you get the full deduction of the charitable contribution. If the stock cost you $50 a share three years ago, and it’s now worth $100 a share, gifting it is a way to take advantage of the return and avoid additional taxes.
The Many Returns on Gifts
My client Barbara’s situation exemplifies another smart use of charitable gifting. Her father, Nick, was an entrepreneur who owned a pipe manufacturing business in the Midwest, and Barbara grew up doing the books and employee management.
Her brothers stayed with the business after college. Barbara married and became a public school teacher. However, she continued to help with the family business when needed. When Nick and his sons received the opportunity to sell the business, Nick wanted to make sure Barbara was recognized for her contribution.
Nick sold the business to another small manufacturing company, and he agreed to take payments on the sale price over the next five years. Nick made Barbara a shareholder, so she also received a portion of those loan payments.
Barbara and her husband, also a teacher, had lived a frugal lifestyle their entire lives. They had raised four children in a modest home, and the money from the sale of the family business was a windfall for them. The couple offset the income related to the loan payments by making periodic gifts on an annual basis to a donor-advised fund, which mitigated the tax impacts. They also set up educational trusts for their grandkids, segregating the assets and thus not subjecting them down the line to estate tax.