Question: I own nonqualified stock options that are expiring next month. Considering the current market conditions, I plan to exercise these options and immediately sell the stock. I would like to donate the stock or sales proceeds to our private family foundation.
The problem is, I don’t have enough liquid assets to exercise the options, and I don’t want to borrow from a bank for a “cashless exercise.” My mother, the foundation manager, suggested that I borrow the cash needed to exercise the options from the foundation and afterwards donate the stock to the foundation.
If I borrow from the foundation, can I still deduct the value of the donated stock on my tax return?
Answer: There’s actually a multiple-part answer to your question, but the short answer is that you cannot—or at the very least, the transaction will cost more than you think.
The first obstacle is the “self-dealing” rule. While borrowing funds from the foundation at the market interest rate appears to be an equitable transaction for you and the foundation, this seemingly innocent transaction is explicitly prohibited in the Internal Revenue Code as an act of self-dealing.
Self-dealing is generally defined as a direct or indirect transaction between a disqualified person and a private foundation. Specifically, an act of self-dealing includes the lending of money or other extension of credit between a private foundation and a disqualified person. A disqualified person can be an individual, trust, estate, partnership, LLC, association, or a corporation that meets any of the criteria listed in IRC § 4946(a). You should note that foundation managers and trustees and their family members are “disqualified persons” with respect to a foundation. Thus, you as a family member and your mother as the foundation manager are disqualified persons.
An excise tax is imposed on each act of self-dealing. If a transaction is deemed to be an act of self-dealing, two tiers of excise taxes will be imposed. Generally, the first tier consists of an excise tax equal to 5 percent of the amount involved, payable by the disqualified person who participated in the transaction. Also in the first tier is a tax of 2.5 percent, which may be imposed on the participating foundation manager (your mother) if she is aware that the act constitutes an act of self-dealing. This tax quickly escalates to a second-tier tax as high as 200 percent if the act of self-dealing is not corrected.
The intent behind these strict rules was not to punish exempt organizations, but to discourage abusive financial transactions involving private foundations and persons closely associated with the foundations. Because of the self-dealing rules and the excise taxes, you may find it more beneficial, logistically and financially, to borrow from another source.
Assuming you borrow from an outside source, you may gift the stock to the foundation immediately after exercise. The gift of stock would be deductible as a charitable contribution subject to the 20 percent adjusted gross income limitation on gifts of appreciated property to a private foundation. Because your stock is short-term capital gain property, your deduction will be limited to your basis.
Another alternative is to make an immediate sale upon exercise and then donate the sale proceeds to the foundation. You should not owe much capital gains tax based on the immediate sale alone since the spread between your new basis and the sale price would most likely be minimal. The benefit is that cash contributions to private foundations are allowable at higher limits—cash gifts to foundations are deductible subject to the higher 30 percent AGI limitation.
As an aside, even if you were not a disqualified person and you managed to borrow from the foundation to exercise your stock options and donate the proceeds, you would probably still not receive a full charitable deduction. Unless you structured it otherwise, a portion of your “gift” might be considered repayment of your loan, and your charitable deduction would need to be adjusted to reflect the repayment.
Karlylle Youngman is a tax manager specializing in personal financial planning for KPMG LLP. Julie Kramer-McNatt is a senior tax manager specializing in personal financial planning for KPMG LLP. Both specialize in the taxation of high net worth individuals and small businesses; transfer tax planning for state, gift, and generation-skipping transfer taxes; and charitable planning. The questions and answers presented here are illustrative only and should not be considered tax or legal advice. Send your legal, acounting, or other practical questions to DonorQandQ@philanthropyroundtable.org.