Question: My husband is the founder of widgets2you.com, which has just gone through an IPO. He has substantial amounts of stock and vested stock options in the company. We would like to use some of these assets to make a gift to charity. Are there any strategies we should follow to get a better tax advantage?
Answer: Strategy is key here because gifts of stock options tend to be more advantageous for companies than for individuals. First of all, individuals are typically barred from transferring stock options to anyone except family members. In the unusual case where the options can be contributed to a charity, the option holder will recognize income to the extent of the difference between the exercise price and the fair market value of the stock, either at the time of the gift or the time the option is exercised. Although the IRS has not officially ruled on the valuation of stock options transferred as charitable gifts, it has said that for estate and gift tax purposes, stock options can be valued by recognized option pricing methods, like the “Black-Scholes” method. Under these methods, the value of the option will almost certainly be less than the amount of income you will be forced to recognize from the option. Therefore, the gift may actually result in a tax cost rather than a tax benefit.
On the other hand, your husband’s company, whizbang.com, could earn a valuable tax benefit if it is willing to support a charity by making a gift of stock options directly to the charity. In that instance, the IRS has clearly ruled that the company will get a deduction at the time the charity exercises the options. The deduction will be the difference between the exercise price and the fair market value of the stock at the time the options are exercised. The cost to whizbang.com of issuing the option should be modest, and will be reduced further by the payment the charity must make to purchase the stock under the option. The company’s deduction will include stock appreciation generated in the market, resulting in a net tax benefit for the company.
Question: As a foundation trustee, I have heard that I should be paying attention to intermediate sanctions. What are intermediate sanctions, and why do they matter to me, since they apply only to public charities and not to private foundations?
Answer: Intermediate sanctions are a set of penalty excise taxes administered by the IRS. They affect people who use their influence over a public charity to take improper advantage of the charity. For example, the taxes would apply to the CEO of a public charity who arranges to be paid more than reasonable compensation for his services, or to a board member who buys a piece of property from the charity for less than its fair market value. The person who reaps this kind of “excess benefit” is the one who owes the tax, but if the excess benefit is not repaid to the charity, a substantially larger second-tier tax can apply as well. Donors who sit on nonprofit boards should know that a tax can also be imposed on directors and officers who knowingly and intentionally participate in providing the excess benefit. The taxes are called intermediate sanctions because they give the IRS an alternative to outright revoking an organization’s tax-exempt status.
Private foundation trustees will recognize that intermediate sanctions are very similar to the taxes that apply to private foundation self-dealing. The resemblance is intentional though not complete. The private foundation self-dealing rules are absolute in barring certain transactions between the foundation and the individuals who control the foundation (so-called “disqualified persons”) including transactions like rental of property or loans. The intermediate sanctions rules do not place an absolute bar on any type of transaction, though they do test all transactions with controlling persons to ensure they are at market rates or in the charity’s favor.
The overlap between the self-dealing rules and the intermediate sanctions rules makes the intermediate sanctions rules of interest to trustees of private foundations. The IRS has issued detailed proposed regulations on intermediate sanctions that give useful guidance on procedures charities can follow to help establish that they are paying reasonable compensation. As IRS has provided limited guidance on reasonable compensation under the self-dealing rules, private foundations may find the intermediate sanctions guidance helpful when setting compensation for key executives or other disqualified persons who get paid for their services.
Catherine E. Livingston is a partner in the exempt organizations practice group of the law firm Caplin & Drysdale. For more information on the contents of this article or the services Caplin & Drysdale provides to private foundations, please contact Ms. Livingston at (202) 862-5089.
The above advice is intended to be general in nature. Consult your own tax and legal advisers to discuss endowed chairs before entering into a donor agreement.