Welcome back to our two-part series on how to use equity compensation to optimize your charitable contributions to a Donor Advised Fund (DAF).
In Part 1, we covered two ways to maximize both your tax benefits, as well as the gift value for your intended recipients. To achieve this win-win ideal, it’s important to be deliberate about which equity compensation share lots you donate, as well as whether you donate them as post-sale cash proceeds, or unsold shares. We concluded that cash isn’t necessarily king when donating to a DAF. Directly donating low basis, long-term shares usually reigns supreme.
Today, we’ll turn to why it’s also important to be deliberate about the origin of your donated shares. Specifically, which origins will help you achieve that low-basis, long-term sweet spot for gifting? To make that determination, we begin by identifying where the shares came from, such as: restricted stock units, restricted stock, non-qualified stock options, or incentive stock options.
Donating Shares From Unsold Vested RSUs
Generally speaking, restricted stock units are taxed at their fair market value (FMV) when they vest and are no longer subject to a substantial risk of forfeiture. The income tax due upon vesting is often covered through a share-withholding or cashless transaction—so you may scarcely notice you’ve paid it. Taxes are typically withheld at a Federal 22% statutory rate (or 37% if it’s over $1 million in supplemental income) plus Social Security, Medicare, and state income tax. After you’ve surrendered the units to cover all that, the remaining shares are deposited into an investment account.
Your newly acquired shares’ cost basis is generally equal to the FMV on their vesting date, which is also the holding period date for figuring their short- and long-term capital gains.
As such, recently vested RSUs are likely to be high basis and short-term, which means they may not be the best choice for gifting to charity. If they appreciate over time and become a long-term holding, they may become a more attractive gift.
Shares from Restricted Stock Awards With an 83(b) Election
Of course, there are exceptions to every rule. When it comes to restricted stock, there’s an exception if you’ve made an 83(b) election on restricted stock awards (not to be confused with restricted stock units, which aren’t eligible for 83(b) election). With an 83(b) election, you choose to pay income tax on the value of the restricted stock at grant, instead of when it vests. Typically, you opt for this election when the stock price seems low, you expect significant growth, and you hope to mitigate the tax impact.
Your 83(b)-elected stock may be a great gift to donate if it has highly appreciated by the time it vests, and meets the desirable low-basis, long-term features we described in Part 1.
Donating Shares From Non-Qualified Stock Options (NQSOs)
For non-qualified stock options, there are a few variations to consider.
Exercised and Held NQSOs: If your shares originated from an exercise and hold of non-qualified stock options, they generally look and feel like vested RSUs and/or shares owned outright. Their cost basis is often the FMV at exercise, and the holding period for short- and long-term capital gains starts on the date of exercise. If you’ve held your exercised NQSO shares for more than a year and they’ve significantly increased in value, they may be good shares to contribute. If you’ve recently exercised and held shares, they may not be so good, particularly if they are short-term and/or the price is at or near its basis.
NQSOs With an 83(b) Election: Just as with restricted stock described above, NQSOs could be ripe for donation if you’ve exercised shares that originated from an 83(b) election, they have a low-cost basis, and you’ve held them long-term (longer than a year).
Vested and Unexercised NQSOs: You may want to hold off on donating these to a DAF. First, you likely cannot transfer unexercised NQSOs directly to a Donor Advised Fund. The work-around would be to exercise them, create a taxable event, and use the after-tax proceeds or net shares to fund the DAF.
Continuing with our model from Part 1, [hyperlink] we can illustrate how each of these Donation Types would play out:
- Exercise and sell 10,000 NQSO shares and contribute the after-tax proceeds
- Calculate the number of NQSO shares required to contribute the full $500,000
|Donation Type||Gift Value||Cost Basis||Taxable Gain||Tax Due||After-Tax Value||DAF Contribution||Tax Benefit||Out-of-Pocket “Cost”|
Donation Type 1: In the first example, we can see the value of the NQSO is $490,000 (which is less than stock owned outright due to the $1 per option cost to exercise). If you plan to exercise the option, sell the shares, pay the tax, and contribute the after-tax dollars, the total contribution to the DAF would be $308,700, with a total out-of-pocket cost to the donor of $375,781.
Donation Type 2: What if you’d like donate a full, after-tax value of $500,000, as we illustrated in previous examples from Part 1? This would require more than 10,000 NQSOs. Specifically (in our illustration), you’d need to exercise and sell 16,197 shares, with a pre-tax value of $793,653.
[(FMV – Strike) x NQSO Required] x (1 – Tax Rate) = Desired Gift
[(50 – 1) x NQSO Required] x (1 – 0.37) = $500,000
NQSO Required = 16,197
The takeaway here? For either Donation Type 1 or 2, its relatively expensive to use unexercised NQSOs to fund a DAF. Only NQSOs you’ve exercised earlier and held long enough to benefit from meaningful price appreciation should be considered as viable options for funding a DAF.
Donating Shares from Incentive Stock Options
If you have incentive stock options (ISOs), you are likely already familiar with the additional complications they may bring as you seek to navigate alternative minimum tax (AMT) and AMT credit ramifications, as well as the minimum required holding period for a qualifying disposition.
For these reasons, for shares originating from an ISO exercise and hold, you may need to take a deeper dive before contributing them to a DAF. It’s a balancing act:
- Tax Advantages: If you contribute unsold qualified ISO shares to a donor advised fund, you can reap the same benefits you would from contributing any other long-term shares. This includes receiving a tax deduction for the FMV at contribution, and eliminating the long-term capital gain you’d otherwise incur when selling the appreciated shares.
- AMT Obstacles: However, if you contribute unsold qualified shares to a DAF, you haven’t sold them. This means you won’t receive a negative adjustment for figuring the AMT, which may cause a delay in how quickly you receive your AMT credit.
- Tax Traps: If you instead contribute disqualified unsold shares, they’ll be treated as if you sold them prior to the donation. This will create a taxable event subject to ordinary income rates and capital asset tax treatment (if any).
Digging into the details, we can examine the following scenarios in the table below:
- Exercise and sell unvested (disqualified) ISO shares and contribute the after-tax cash
- Sell qualified ISO shares and contribute cash
- Contribute qualified ISO shares directly to the DAF
|Donation Type||Value||Cost Basis||Taxable Gain||Tax Due||After-Tax Value||Contribution to Charity||Tax Saving||Out of Pocket “Cost”|
Donation Type 3: If you exercise and sell your unvested ISOs and contribute the after-tax value to a DAF, the outcome looks very similar to the exercise and sale of NQSOs. You have a disqualifying disposition, you pay ordinary income on the taxable gain, the charity receives less, and your potential tax savings is less.
Donation Type 4: If you sell qualified ISOs and contribute the after-tax amount, you recognize long term capital gains as a qualifying disposition. You also receive a negative AMT adjustment for the sale of qualified ISOs, potentially accelerating an AMT credit, if owed.
Donation Type 5: If you give qualified ISOs to charity as unsold stock, you’ll avoid recognizing long-term capital gains, but you’ll also forgo the potential negative AMT offset for the sale of qualified ISOs.
So, how do you know how to proceed? Read on, and we’ll describe how to add AMT planning to the mix.
AMT Credit for Incentive Stock Options
If you pay AMT in a year that you exercise and hold incentive stock options, you might be credited back that AMT amount in future years. Generally speaking, the higher the AMT basis of your ISO shares (the higher the FMV at exercise), the more AMT you may pay in the year of exercise, and the more AMT credit you may have due.
The thing is, the credit may come back to you sooner or later:
AMT Credit Sooner: You can often accelerate AMT credits back sooner in years you sell ISO shares as a qualified disposition, particularly if the shares sell at a price higher than the FMV at exercise.
AMT Credit Later: Even if you do not sell the ISO shares, eligible AMT credit often continues to come back every year, albeit at a slower rate.
This is important. Even if you donate qualified ISO shares and forgo a negative AMT adjustment on your personal return that year, it’s not as if eligible AMT credit is lost. It’s just more likely to take longer to return. If you have significant AMT carry-forward, this might figure into your decision-making. It may be less critical if the carry-forward is small, or the AMT credit is likely to be paid in short order.
To illustrate how and why this may matter, let’s continue our illustration above by comparing two qualified ISOs lot donations.
Donation Type 6: First we’ll assume an AMT basis of $2 per share as the FMV at exercise.
Donation Type 7: Next, we’ll assume an AMT basis of $45 per share.
For both types, we’ll assume you paid AMT at 28% in the year of exercise, and the full AMT credit was received in the year you sold your shares. We can thus figure the following AMT amounts paid, and AMT credits subsequently due to you in the year of sale:
- 10,000 ISO at $2 per share = $10,000 bargain element = $2,800 AMT Due
- 10,000 ISO at $45 per share = $440,000 bargain element = $123,200 AMT Due
If you donate these shares to your DAF, forgoing the negative adjustment for the sale of the qualified shares, we can refigure the “total cost” by assuming this is a “cost” for the year of sale.
Net-net, forgoing the AMT credit significantly increases your total out-of-pocket cost for the high AMT basis in Donation Type 7 relative to the low AMT basis shares in Donation Type 6.
|Donation Type||Value||Strike||AMT Basis||Reg Gain – AMT Gain Delta||Value at 28%||Contribution to Charity||Charitable Benefit Adjusted||Total out of Pocket “Cost”|
Again, it’s important to note: Your “total cost” here is actually more of a cash-flow timing issue than dollars lost forever. Assuming you remain alive and continue to receive the credits, they will come back over time. However, it may take longer when you donate shares with a higher AMT cost basis.
Key Takeaways When Donating Equity Compensation to a Donor Advised Fund
That was a lot to take in. Let’s summarize the critical points from today’s piece:
- Unsold, Vested RSUs: Recently vested RSUs are likely to be high basis and short-term; probably not the best choice for gifting to charity. If they appreciate over time and become a long-term holding, they may become a more attractive gift.
- Restricted Stock Awards w/83(b) Election: Your 83(b)-elected stock may be a great gift if it has highly appreciated and meets the desirable low-basis, long-term features.
- Exercised and Held NQSOs: If you’ve held your exercised shares for more than a year and they’ve significantly increased in value, they may be good shares to contribute. If they’re recently exercised and held, short-term, and/or at or near its basis, you may want to wait.
- NQSOs w/83(b) Election: These could be ripe for donation once they have a low-cost basis, and you’ve held them long-term.
- Vested and Unexercised NQSOs: You cannot transfer unexercised NQSOs to a DAF.
- Incentive Stock Options: Unsold qualified ISO shares offer the same benefits as any other low basis, long-term share DAF contribution. However, watch for AMT complications. The more AMT credit carry-forward you have, and/or the longer it may take to use it, the more heavily it might factor into your decision-making.
That’s the broad sweep. If you are considering contributing equity compensation to a donor advised fund (or any charitable entity), it’s important to mind the details.
Donating shares in kind rather than as cash can be more tax-efficient for you. But if you have compensation from many years and many sources, each lot and type could have a different impact on the results. Working with your advisors, you can evaluate what shares might be best to give, and why, and develop a strategy to maximize the intended impact for everyone involved.
Speaking of which, there’s one more detail, which is arguably more important than all this technical planning combined:
Why, and to what extent do you want to fund a Donor Advised Fund to begin with?
Tax savings are nice. But don’t forget, you’re ultimately giving away a chunk of your wealth. If your greater financial goals include a noticeable amount of charitable giving, contributing executive compensation to a donor advised fund can be a great way to achieve your aim. If your only intent is to minimize your tax bill, you may want to look elsewhere.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.