Your lock-up period for selling shares acquired from an initial public offering (IPO) is about to end and you’re about to receive a significant windfall – how can you incorporate charitable giving into your financial plan?
First, as discussed in our prior blog post IPO Windfall? Consider the Big Picture First, make sure you have a good sense of what this windfall means for your long-term financial outlook. Do you have enough assets to meet your goals for financial security? Do you have enough money to purchase the home you’ve always wanted or to fund your children’s college education? Once you are confident that you are likely to meet all of these goals, you can begin to think about how to incorporate charitable giving into your plan in a tax-advantageous manner.
Is Charitable Giving Important to You?
First, ask yourself how important charitable giving is to you. This is a significant question because giving to charity typically reduces your overall wealth. For example, if you give $10,000 to charity and receive a tax deduction worth approximately $4,000, you still have $6,000 less in overall wealth than had you not given anything to charity. Thus, giving to charity should be based upon your desire to give something back to the causes you care about. That said, there are some tax benefits associated with charitable giving that can dramatically reduce the cost of your gift.
Once your lock-up period ends and you begin to sell restricted stock or exercise options, you’re likely to be in a very high tax bracket. This will likely be the case for a few years as you sell restricted shares or exercise and sell options on a regular basis to diversify. Combined (federal and state) ordinary income tax rates for California taxpayers can exceed 50% and combined long-term capital gains can be taxed at a rate as high as 37%. Thus, if you have a desire to give back, now is the time to consider charitable gifts.
When calculating your income tax due, you can either reduce your taxable income by taking the standard deduction (which is $24,400 in 2019 for married couples, not including any add-ons that can increase it) or you can itemize your deductions (assuming the total of your itemized deductions exceeds the standard deduction). Given that the deduction for state/local tax is currently capped at $10,000, the mortgage interest deduction and charitable deductions are what are going to push you over the $24,400 level necessary to itemize. If you don’t own a home, you will not have any mortgage interest to deduct; therefore, the charitable deduction becomes even more important toward increasing your itemized deductions above the $24,000 level.
Best Ways to Give
Typically, the most beneficial asset to give to charity is highly appreciated (or low basis) stock that has been held long term (more than one year). For those going through an IPO that typically means giving shares you now own outright because you’ve exercised incentive stock options and held them one year past the exercise date and two years past the grant date. Your donation could also include shares you’ve acquired through an employee stock purchase plan and have held longer than one year.
Why give long-term appreciated stock? The primary reasons are that you get an income tax deduction for your contribution and you avoid capital gains tax on the stock you are donating. For example, let’s suppose you’ve owned your company’s stock for over one year (making it a long-term gain). Your basis (i.e., what you paid for it) in the stock is $10,000 and it’s now worth $110,000. Let’s also assume your long-term capital gains tax rate is 15% for federal and 10% for state, totaling 25%. If you were to sell the stock today, you would have a long-term capital gain of $100,000, which, if taxed at 25%, would result in a $25,000 tax liability. You would net $85,000 after tax on the sale ($110,000 – $25,000).
Now, let’s assume you give those same shares valued at $110,000 to a qualified charity. Assuming your ordinary income tax bracket is a combined 40% for federal and state, your $110,000 gift would result in a $44,000 tax deduction ($110,000 x 40%). (Note, there may be limitations on how much you can deduct depending on your income and the type of charitable organization you are giving to but this is beyond the scope of this article). Moreover, because you are giving the shares to charity, you do not have to pay any tax on the gains. Therefore, you are avoiding capital gains tax of $25,000 ($100,000 gain x 25% capital gains tax rate). In essence, your charitable gift of $110,000 effectively cost you only $41,000! ($110,000 gift – $44,000 income tax deduction – $25,000 capital gains tax avoided).
Continuing the example above, you could take your gift one step further and donate the stock to a charitable giving vehicle known as a donor-advised fund (DAF). Many individuals do not know which charities they want to donate to or wish to spread out their gifts to a variety of charities over a longer period of time. One way to do that, while still receiving a tax deduction in the current tax year, is through a DAF. A DAF is a 501(c)(3) charity that is specifically designed to help donors facilitate a long-term charitable giving approach. Just like with any 501(c)(3) charity, your contribution to a DAF is tax deductible in the year you make the contribution. However, once your contribution is received into the DAF, you can sell your security with no capital gains and reinvest the full proceeds into more diversified investments. You can make grants out of the DAF to charities at your leisure or continue to allow the funds to grow over time, potentially allowing you to make bigger gifts in the future. Note that your grants from the DAF to charities are no longer tax deductible because you’ve already received the tax deduction from your initial donation. You can typically name your DAF (e.g., the John Doe Charitable Fund) and, although you can “advise” where you want the grants to go (typically to approved 501(c)(3) charities), the assets are technically no longer yours. DAFs are an excellent way to facilitate your charitable giving and can be far less burdensome and costly than setting up a private foundation.
In addition to DAFs, there are a number of other techniques that can be used to facilitate giving depending on your goals. These techniques can be complex and must be structured properly with an attorney to ensure that they achieve your intended tax, philanthropic, and estate objectives. The following are two examples:
- Charitable Remainder Trust (CRT): A charitable remainder trust allows you to receive a partial deduction for your donation while receiving an income stream for life or a period of years. Whatever is left at the end of your life or the specified term passes to charity A CRT often allows the donor to retain control of the investment of the assets.
- Charitable Lead Trust (CLT): A CLT is the opposite of a CRT – you make a donation and the charity receives the income for your life. At the end of your life, whatever assets that remain in the trust are passed to beneficiaries. This technique can reduce estate and gift tax in certain situations.
An IPO windfall not only helps you secure your financial future but also can help you lead the life you want to live. A well-thought-out charitable giving strategy can help you make a big impact while also allowing you to take advantage of tax and other benefits available.
Cerity Partners LLC (“Cerity Partners”) is a registered investment adviser with offices in California, Colorado, Florida, Illinois, Ohio, Michigan, New York, Massachusetts, and Texas. Registration of an Investment Advisor does not imply any level of skill or training. This commentary is limited to general information, and should not be construed as personal tax, legal, or investment advice. There is no guarantee that the views and opinions expressed in this piece will come to pass. The information is deemed reliable as of the date of this commentary, but is not guaranteed, and subject to change without notice. It should not be considered as an offer to sell or a solicitation of an offer to buy any security.