Can you donate privately owned business interests to private foundations?

by: Kyle Anderson
February 8, 2024
Cash Drawer

Yes, donating privately owned business interests to private foundations is indeed possible, although it involves a myriad of complex legal and tax considerations. The array of business interests eligible for donation is broad, spanning shares in closely held corporations (both C and S corporations), memberships in LLCs, interests in limited partnerships, stakes in private equity and hedge funds, and pre-IPO shares. Prospective donors should be prepared for the intricate task of navigating through a dense regulatory landscape and complicated tax implications. This undertaking involves grappling with stringent tax deduction rules, potential pitfalls of donating businesses burdened with debt, the issue of avoiding pre-arranged sales, adherence to IRS regulations concerning excess business holdings, the potential imposition of unrelated business income tax (UBIT), and the necessity of obtaining a professional valuation and appraisal. Despite these formidable obstacles and challenges, there still are compelling reasons for business owners to consider such donations.

The Tax Deduction Conundrum for Private Business Donations

The hesitancy among business owners to donate their private business interests to private foundations largely stems from the less favorable tax deduction rules governing charitable donations. These rules restrict donors to deducting the lesser of the cost basis or the fair market value of the donated private business interest. For a business whose value has significantly appreciated, this limitation severely constrains the tax deduction benefit. Take, for instance, a business that was initially started with just $50,000 but is now valued at over $1,000,000. In such a case, the donor could take a tax deduction only for the initial $50,000 investment, resulting in a less than ideal tax scenario. This disparity is even more pronounced when compared with the tax deduction benefit available for donations of private businesses made to public charities, where the full market value of the donated asset is generally deductible. This discrepancy significantly diminishes the incentive for private business owners to donate their business interests to private foundations.

Furthermore, the deduction limits as a percentage of adjusted gross income (AGI) for donations of private businesses are more generous when directed to public charities rather than private foundations. Specifically, while the AGI limit for donations to public charities stands at 30%, contributions to private foundations are limited to a 20% AGI cap. Regardless of this difference, both categories of donations benefit from the ability to carry forward any unused deductions for up to five years, providing a window to use surplus deductions constrained by AGI limits over time.

Navigating the Pitfalls of Debt-Financed Property Donations

Donating privately held business interests encumbered with significant debt can possibly cause those interests to be seen as “debt-financed property.” This depends on their capital structure and the type of ownership the donor has. The designation of debt-financed property has significant implications for donations to private foundations – it suggests that the foundation could be assuming the business owner’s debt. This scenario directly conflicts with self-dealing regulations that strictly prohibit private foundations from taking on any debts from donors. Consequently, donations of business interests burdened with considerable debt may not be permissible under these rules.

Specifically, transferring a debt-burdened property to a private foundation might constitute self-dealing, especially if it serves to alleviate the donor's financial burdens by shifting the liability to the foundation. Such a transfer may unfairly benefit the donor, contradicting the purpose of the self-dealing regulations, which are aimed at preventing the exploitation of a foundation by foundation insiders. To avoid this pitfall, it is crucial that any donation involving a business interest laden with substantial debt undergoes rigorous scrutiny to ensure adherence to self-dealing laws. Ignoring these regulations can lead to severe penalties affecting both the donor and the foundation's leadership.

When considering the donation of a business with significant debt, consulting with professionals intimately acquainted with tax law is strongly recommended given the intricate legal and tax considerations that these transactions entail. In certain instances, it may also be prudent to seek direct confirmation from the IRS regarding the classification of the transaction. In some cases, a business interest heavily burdened with debt may need to address and reduce the liabilities before a donation is considered permissible.

Steering Clear of Pre-arranged Sales

When considering the donation of a privately held business interest to a private foundation, particularly when a post-donation sale is expected, it's essential to steer clear of any suggestions of a pre-arranged sale to a third party. The IRS has the right to examine these transactions to prevent donors from exploiting private foundations as intermediaries for facilitating sales, while attempting to claim tax deductions on transactions that otherwise would represent capital gains. To preserve the donation's integrity, it's imperative that no sale of the business interest is finalized or even appears to be pre-arranged before the donation takes place. The IRS diligently monitors for transactions that suggest pre-arrangement, and has the authority to reclassify them as direct sales from the donor to the ultimate purchaser.

Maintaining the private foundation's independent decision-making authority regarding the future of donated business interests—whether to hold or sell—is crucial. While donors are permitted to suggest potential buyers, they must avoid any form of agreement or commitment that could potentially restrict the foundation's freedom. Ensuring that the foundation retains exclusive authority in negotiations with any prospective buyers is vital to prevent regulatory complications.

Understanding Excess Business Holdings Regulations

The donation of private business interests to private foundations also necessitates a comprehensive understanding of excess business holdings rules. These regulations are designed to prevent private foundations from acquiring a controlling interest in for-profit businesses, thus ensuring they are not unfairly competing in the for-profit economy. To avoid penalties, foundations and their associated disqualified persons, which include managers, major contributors, and their families, are limited to owning no more than 20% of a business’ voting stock. This limit increases to 35% if the business is not under the control of disqualified persons. Surpassing these limits incurs severe financial penalties, starting with a 10% excise tax that can rise to 200% if the issue remains unaddressed.

In order to maintain compliance, strategic planning is strongly suggested before acquiring official business ownership. Notably though, in the case of donations or bequests, foundations generally benefit from a five-year grace period to rectify any excess business holdings (versus buying a business interest directly, which essentially has no grace period).  The regulations also allow for a few exceptions, such as for businesses primarily earning passive income, businesses that are directly related to the foundation's charitable mission, and a specific exception for Newman's Own type businesses. This unique case enables a foundation to wholly own a for-profit entity under strict conditions, including donating 100% of profits to the foundation and maintaining governance and operational independence between the company and the foundation. This exception was established to accommodate the unique structure of Newman's Own, a food and beverage company founded by actor Paul Newman in 1982 that always donated 100% of its profits to charity.

Assessing the Impact of Unrelated Business Income Tax (UBIT)

The influence of Unrelated Business Income Tax (UBIT) is another critical consideration for private foundations that may acquire interests in private businesses. UBIT applies to business income from activities not directly related to a foundation's exempt charitable mission, including revenue from commercial ventures or business interests the foundation owns. UBIT imposes a 21% federal rate on such income, significantly higher than the standard 1.39% excise tax on standard investment income from sources including public company dividends, bond interest, and capital gains from the sale of securities. Additionally, unrelated business income can trigger state-level taxes that, depending on the jurisdiction, can surpass 10%. This dual taxation at the federal and state level increases the overall tax burden on unrelated business income and often necessitates the filing of state tax returns, introducing an additional layer of compliance and administrative responsibility.

The dual impact of federal and state taxes on unrelated business income highlights the importance of conducting a careful financial analysis when considering private businesses as a component of a foundation’s investment portfolio. It is essential for foundations to weigh the overall tax implications carefully, particularly in comparison to public securities, which benefit from a more favorable federal tax rate of 1.39% and are usually exempt from state taxes. In some instances, divesting from private business interests and reallocating the proceeds into public securities might be a more financially sound strategy. However, a thorough financial analysis is required to make an informed decision.

Moreover, the role of UBI within a foundation's financial framework calls for vigilant oversight. The IRS has the authority to challenge a foundation’s tax-exempt status if the UBI activities constitute a “substantial” part of its operations, potentially undermining the foundation's primary charitable purpose. While no precise threshold exists for "acceptable" amounts of UBI, the IRS evaluates the extent of such income in relation to the foundation's charitable activities. A high level of unrelated business income might suggest a shift away from the foundation's core mission thereby endangering its tax-exempt status. It's essential, then, for foundations to strike a careful balance, ensuring that unrelated business income activities are kept in check and do not dominate their core charitable functions.

The Importance of Valuation and Appraisal in Donations

When considering the donation of privately held business interests to private foundations, it's crucial for donors to consider the complexities of the valuation and appraisal process from the outset. This process is time-consuming and costly in nature, so it’s important for donors to prioritize understanding and addressing these requirements. A valid appraisal is a critical aspect of ensuring the donation complies with IRS regulations and qualifies for tax deductions.

The IRS requires that any business interest donated with a value exceeding $5,000 be supported by a qualified appraisal, which must adhere to strict guidelines, including timing. Specifically, the appraisal should be performed no more than 60 days before the donation to accurately reflect current market conditions. The qualifications of the appraiser are also paramount, demanding proven expertise in evaluating the specific type of business interest being donated. A thorough appraisal meticulously documents all important aspects of the business, highlighting the date of donation and carefully assesses the fair market value—the price at which the property would exchange hands between a well-informed buyer and seller, with neither being under any pressure to complete the transaction.

Motivations for Donating Private Business Interests

Despite the challenges outlined above, there are compelling reasons to donate private business interests to private foundations. Foremost among these is simply the opportunity to create a significant, lasting philanthropic impact, prioritizing charity over the pursuit of potential tax benefits. Transferring a successful and valuable private business interest allows donors to allocate substantial resources towards charitable causes they are passionate about. For affluent families, whose main source of wealth is their private business, this type of donation may represent their best, or sometimes only, option to support a private foundation.

Furthermore, the financial appeal of donating a private business is more attractive when its cost basis aligns closely with its fair market value—an occurrence more likely if the business was purchased rather than built from the ground up. Such circumstances enhance the tax efficiency of the donation by avoiding the typical limitations on tax deductions, which arise when there is a large difference between the cost basis and the fair market value.

Lastly, effective estate planning can significantly mitigate the thorniest tax inefficiencies typically associated with donating private business interests to private foundations. By strategically bequeathing a private business interest at death to a foundation, donors can circumvent the restrictive limits on charitable deductions that would otherwise apply. A donation upon death removes the value of the business interest from the decedent’s estate for estate tax calculations. This can lead to considerable tax savings, especially for high-net-worth estates, making the donation of a private business interest a relatively common practice. Moreover, this form of contribution eradicates the potential capital gains tax liabilities that would arise from a sale during the donor's lifetime. Once transferred to a private foundation, the business interest receives a basis “step-up” adjustment to reflect fair market value at the donor's death.

Conclusion: Weighing the Decision to Donate

The decision to donate privately held business interests to private foundations is a complex decision that necessitates a thorough understanding of the various legal, tax, and regulatory complexities. Among charitable donations, these gifts stand out for their complexity and the rigorous analysis they require, especially given the dense web of IRS regulations and the specific tax implications involved. Such complexity underscores the critical need for specialized legal and accounting advice, essential for effectively navigating potential risks and ensuring adherence to applicable laws and regulations.

This philanthropic approach should be contemplated only when the potential donation is substantial enough to justify the investment in professional evaluations of the tax and legal considerations involved. When approached with due diligence, these donations can offer significant benefits for both the donor and the foundation, unlocking vast resources for charitable endeavors. By leveraging private business interests in this way, donors can achieve a lasting impact, contributing significantly to the charitable causes they are passionate about.

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