Question: “Our foundation has close ties to a corporation such that the corporation is a ‘disqualified person’ in relation to the foundation. Can the corporation legally donate stock options to our foundation, or would that constitute illegal ‘self-dealing’?
Answer: ”Yes, if certain careful procedures are followed, as outlined in two recent private letter rulings by the IRS (PLR 200312003 and 200312004).
First let’s quickly review what the law means by ‘disqualified person’ and ‘self-dealing’ in this case. A corporation can be a disqualified person in connection to a foundation if it is a substantial contributor to that foundation, or if any individual who owns over 35 percent of the corporation’s stock is himself a disqualified person because, for example, he or a family member either manages the foundation or is a substantial contributor to it. In the case at hand, self-dealing would involve any sale, exchange, or leasing of property, or any lending of money or extension of credit.
Let us say that ‘BigCorp,’ a publicly held corporation whose stock is listed on the New York Stock Exchange, is a disqualified person for ‘Foundation.’ BigCorp pledges to the Foundation stock options that allow the bearer to acquire BigCorp stock at the stock’s closing price on the day the options are issued. Sounds fine so far, but when the options are exercised and actual stock is purchased, Foundation would be buying stock from BigCorp. Because the company is a disqualified person, this sale would be a prohibited act of self-dealing.
The IRS rulings approved of two possible ways of getting around this.
Scenario 1: The Foundation may transfer the options to one or more unrelated charitable organizations, which would be free to exercise them without worrying about self-dealing. For example, if the Foundation’s mission includes support for charter schools, it may pass on the stock options to a charter management organization (CMO), a public charity not under its legal control. When the stock price of BigCorp rises above the price at which the options permit their holder to purchase BigCorp stock, the CMO could buy shares at the option price, sell them at the higher market price, and keep the profit.
The IRS even said that the Foundation could, if it wanted, receive some monetary consideration for transferring the options. To continue our example, the CMO could pay Foundation a price for the options equal to their appreciated value, less an agreed-upon discount.
Scenario 2: BigCorp and Foundation could arrange a ‘cashless’ or ‘net exercise’ transaction in which the Foundation would retain the options and end up receiving the profit produced by the stock’s appreciated value. For example, let us say BigCorp gives the Foundation stock options good for 100 shares at that day’s price of $50. A month later, the market price of the stock has risen to $75 per share, and the appreciated value of the options is $25 per share, or $2,500 total. The Foundation may then give the options to BigCorp and receive in return $2,500 worth of actual BigCorp stock, which Foundation is free to sell.
The IRS also addressed two other tax issues in such cases:
Unrelated Business Income: Under Scenario 1, if Foundation sold the options to an unrelated charity, the money received from the charity would not be taxable as unrelated business income to the Foundation. Nor, under Scenario 2, would the receipt of stock after a cashless exercise of the options be taxable.
Deductibility of the Contribution: The IRS explained what deduction BigCorp may take for its donation of stock options. In Scenario 1, when Foundation transfers the options to an unrelated charity, BigCorp’s deduction equals the difference between the exercise price and the market value of the stock, and the deduction may be taken when the charity exercises the options. Under Scenario 2, when Foundation exercises the options in a cashless transaction, BigCorp may deduct the value of the stock transferred to the Foundation. (Of course, any deductions are subject to the usual rules and limits on corporate charitable giving.)
A final caveat: Private letter rulings provide guidance on the IRS’s understanding of tax law, but they don’t bind the IRS in future cases. If you’re worried about a similar sort of donation, you may want to obtain your own private letter ruling.
Jerry J. McCoy is an independent attorney in Washington, D.C., specializing in charitable tax planning and foundations. The questions and answers presented here are illustrative only and should not be considered legal advice. Please consult with a nonprofit attorney or other qualified advisor for specific answers.
