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Philanthropy 101

Many people who made money working at a startup want to give back. Here are some of the common ways people give money to charities and some of the different vehicles you can use for your philanthropic efforts.

Charities in the United States and tax deductions

Charities in the United States are almost all organized under Section 501(c)(3) of the Internal Revenue Code, which means they don’t have to pay most forms of federal income tax. To qualify to be exempt from taxes, an organization must be charitable, religious, educational, scientific, or similarly qualified.

Further, donations to qualified 501(c)(3) organizations are eligible to be deducted from the donor’s income for tax purposes. Thus, taxpayers are incentivized to make donations to charities as this can lower their taxes. Also, because of the tax-exempt status of qualified organizations, they frequently play a part in tax minimization planning.

Here is an illustration of how charitable donations reduce a donor’s income tax.

A single filer donor’s income for the year is $900,000; if they do not make donations, they will be paying federal income tax on the full $900,000, coming out to about $295,000, or 33% of the $900,000 gross income. However, if they make $250,000 of donations to qualified organizations, they will only have to pay tax on the remaining $650,000, as they get to deduct the donations from their taxable income. Income tax on the $650,000 would only be about $205,000, which is only 23% of the $900,000 gross income. Taxes go from $295,000 to $205,000. However, the donor also has $250,000 less of assets as well, so while they saved $90,000 of taxes, they have $160,000 less money overall. Do not pursue this strategy unless you really want to give money away.

Deciding how much to give

Choosing how much to give to charitable causes is a decision that will be different for everyone. Most donors use these factors to determine their amount of giving:

  • Their philosophical affiliation and recommendation - many religions recommend a 10% tithe
  • Current life prosperity (Are you particularly comfortable or scrimping and saving?)
  • Gut feeling (Does 10% seem too little or too much?)
  • Needs of their favorite organizations (Does one charity require $25k for a special purpose this year?)
  • Refining over time (How can you improve your back-of-the-envelope calculation?)

What to give – cash or stock?

From a tax and financial perspective, the thing you as an individual (or revocable trust holder) want to be giving away to charity is long term, low basis, public company shares.

Breaking that down more:

Long term: You need to have owned the asset you are donating for over 12 months (the special benefits don’t work if your holding period is less than a year)

Low basis: Basis is your acquisition cost for tax purposes. The goal is to donate the assets with the largest percentage unrealized capital gain (market price over purchase price). Usually, the shares you acquired earliest are the lowest basis shares.

Public: Listed on NASDAQ or NYSE; many charities can only accept stock gifts if they can sell them for cash right away

Shares: Shares are the donatable unit, not options. Employee based option contracts are generally non-transferrable and written so that transfers to a charity would not work

This gifting strategy is more tax efficient than selling your company's stock (which creates a taxable event for you), then donating the remaining cash to your charity. Reducing the tax friction around a gift effectively makes the gift larger. By donating long term, low basis, public company shares, you can avoid having to pay capital gains tax on the appreciation in the donated shares, and in addition you can deduct the donation from your income.

Transferring the shares directly is called transferring “in-kind.” The charity then sells the stock donated “in-kind” for cash and can use the funds like they would a cash contribution. The low cost basis carries over to the charity, and normally the charity would owe capital gains tax after the sale on their realized gain. However, qualified charities are generally exempt from capital gains taxes, so you are able to save the ~20-40% in taxes you would owe if you sold under your name and then donated the cash.

Example

Direct to charity

Most qualified charities can receive an in-kind gift of exchange traded stock. If the charity cannot accept a gift of stock in-kind, you can:

  • gift cash directly (inefficient, but acceptable for small donation amounts)
  • route the donation through a specially designed charitable fund called a “donor-advised fund” (useful for gifting $10,000+)
  • make use of a private foundation (preferred for larger or recurring gifts).

If your stock is not traded on a public exchange, your options are more limited. Some charities will accept private illiquid stock, but many will not. You likely can transfer it to a private foundation, but that has additional complications.

Roughly, the size of the charitable gift determines its preferred form. If the charitable gift is:

  • Less than $1,000, cash is probably the best form.
  • $1,000 to $10,000 could be cash or stock, (or preferably cash from a donor-advised fund).
  • Above $10,000 should be made in long term low basis stock if you have it. Gifts of $10,000+ generally should be made directly to the charity in-kind or in-kind to your donor advised fund or private foundation. The donor advised or foundation then sells the shares received and sends cash to the charitable organization.

Your income tax deduction will depend on the recipient (public charity or private foundation) and the form of the gift (cash or in-kind). Under non-CARES Act years, maximum annual deductions range from 20% for in-kind gifts to private foundations to 60% for cash contributions to public charities. If you cannot use all of your donation deduction in one year, you can carry it forward for up to five years.

Donor-Advised Funds

A donor-advised fund (DAF) is a charitable giving vehicle where a public charity administrator manages donations on behalf of individual donors. A DAF can be thought of as a separate account held with the administrating charity in the name of the donor.

A DAF is basically an intermediary holding vehicle for charitable contributions. The donated funds count as a tax deduction for the donor in the current year (and are no longer included in the donor’s taxable estate). However, the donor does not yet need to direct the funds to an operating charity. Ultimately, the donor will distribute the funds out of the DAF to operating charities, but this can occur over many years. Unlike private foundations, donor advised funds do not have a legally mandated minimum payout requirement. In practice, many administrators will require distributions to occur for a donor and their fund to stay in good standing.

If you have a lot of income in one year that you would like to offset with charitable deductions, but you aren’t sure who you want to give the money to, a donor advised fund can be a very effective planning tool for you.

As an example of a strong use case for a donor advised fund:

  1. In the year following your company’s IPO, you exercise options, sell shares, and otherwise create a sizable taxable income for the year.
  2. Given your liquidity event, you’ve decided you want to fund some charitable contributions.
  3. You create a donor advised fund, transfer long term, low basis stock to it. 4.
  4. The DAF then might sell the stock and reinvest into a diversified portfolio, or it could hold the transferred position.
  5. When you are ready to make a gift to a charity over the next few years, you simply instruct the DAF to do so,
  6. The DAF sells shares if needed, and it sends cash to the recipient charity.

By front-loading many years of charitable giving, you can offset years of unusually high income, thereby avoiding a high marginal tax rate in that year. The large donation to the donor advised fund qualifies as an itemized deduction against your gross income. Since your gross income is so high from the liquidity event, you may be in the highest marginal bracket, or at least higher than your typical bracket. Thus, getting the deduction against the high marginal rate is particularly valuable in the year you have a spike in taxable income.

Outside of those with big one year income spikes, donor advised funds can also be particularly helpful if you plan to give a small amount to many charities. Because you are making small gifts, donating stock in-kind may not be possible. If you donate cash directly, you miss out the capital gains tax saving opportunity. While for each individual transaction, the difference may be small, across many transactions the missed tax savings can become significant. By using a donor advised fund, you can capture the tax savings and still make small dollar cash contributions to your intended operating charities.

You can fund a donor advised fund with cash, but long term, low basis, public company shares are the preferred DAF funding choice because of the extra tax benefits from in-kind share donation.

DAFs are not required to provide the public with their donor listing, which also allows donors to make anonymous gifts.

Private Foundations

Private foundations are charitable organizations that are typically established by an individual, family or corporation to support charitable activities. Private foundations are similar to donor advised funds in serving as an intermediary destination between funds leaving from a donor and being received by an operating charity. By design, most private foundations do not operate themselves but rather direct funds to other charitable organizations which do.

A private foundation is a separate legal entity, with its own board of directors or trustees that oversees it. Because of its independent legal status, a private foundation allows for more control and creative options for a donor than would a DAF that must answer to its administrator.

Private foundations are the optimal structure for those that want to operate a charitable organization and potentially employ a staff, hire investment managers, actively manage grant-making, and sponsor charitable events. Private foundations can hold nearly any kind of asset – including private equity, limited partner interests, real estate, and even intangible personal property. A private foundation can’t just hold its money indefinitely, as the IRS requires private non-operating foundations to distribute 5% of the value of their net investment assets each year either as grants or eligible administrative expenses.

Private foundations are required to file detailed tax returns with the names of board members and donors, grants, investment fees, board and staff compensation, etc., which are public records and easily accessible via the internet.

Private foundations are required to file detailed tax returns with the names of board members and donors, grants, investment fees, board and staff compensation, etc., which are public records and easily accessible via the internet.

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