What Equity Compensation Shares Are the Best to Contribute to a Donor Advised Fund? Part 1

If there’s such a thing as a match made in philanthropic heaven, it may be the ability to donate a portion of your equity compensation shares to a Donor Advised Fund (DAF). DAFs are relatively easy to fund, easy to manage, and they ensure that you get a tax deduction for the full, appreciated value of your donated stock.

A tax deduction that can be especially beneficial in a high-income tax year, as may be the case when you have significant equity compensation activity. Plus, any long-term capital gains on the donated shares can magically disappear.

If you’re charitably inclined to begin with, it doesn’t get much better than that. But before you rush off to sign up, please read on. As usual, there are better and worse ways to deploy a sound strategy to fund your Donor Advised Fun.

In particular, if you want to optimize your tax savings and your DAF charitable contributions, and you have a lot of equity compensation you could tap for this purpose, it’s important to be selective about which shares you use and where they come from.

Share Selection Matters when Donating to a Donor Advised Fund

Once you’ve decided how much you want to contribute, and why, you can focus on what to donate: cash or shares—and if shares, which ones? For this, it’s important to understand how various donations could impact your finances. Big picture, you’ll want to plan on two fronts:

1. Stock Lots: When donating any sort of appreciated assets (versus simply contributing cash), you’ll want to consider each share’s cost basis, holding period, and AMT impact (if necessary).
2. Stock Origins: It’s also important to evaluate the origin of each potential share. Different shares may have come from different types of equity compensation—such as restricted stock units, incentive stock options, or non-qualified stock options—and each may impact your tax return differently after being contributed to a DAF.

In today’s post, we’ll cover how to think through selecting the most tax-effective stock lots for donating to a DAF. In our next post, we’ll follow up with a discussion on stock origins.

Crunching the Numbers: An Illustrative Model

To get started, let’s build a model for comparing strategies. First, we’ll assume the following:

• Total Value of a Donor Advised Fund Gift: $500,000
• Total Shares Available for Gift: 10,000
• Fair Market Value of stock: $50.00/share
• Short Term Capital Gains Rate: 37%
• Long Term Capital Gains Rate: 20%

We’ll also assume the following for the stock’s regular vs. AMT cost bases (AMT basis is of particular importance to shares acquired through an exercise and hold of incentive stock options):

• Regular Cost Basis – Low: $1.00/share
• Regular Cost Basis – High: $45.00/share
• AMT Cost Basis – Low: $2.00/share
• AMT Cost Basis – High: $45.00/share

Now, let’s evaluate the impact of making various types of Donor Advised Fund contributions by filling in the blanks in this chart, and comparing the outcomes:

1. Gift Value: The total value of the DAF contribution.
2. Cost Basis: Subject to the stated low- and high-cost-basis assumptions above. For cash, the cost basis equals the value of the cash itself.
3. Taxable Gain: The gain realized if stock shares are sold before being contributed to the DAF. If shares are donated “in kind,” without selling them first, there is no taxable gain.
4. Tax Due: The tax due is based on the taxable gain and corresponding tax rate for short- or long-term capital gain, again assuming shares are sold prior to the DAF contribution.
5. After-Tax Value: The difference between the Gift Value and Tax Due.
6. DAF Contribution: The amount given to charity based on Donation Type.
7. Tax Benefit: The DAF Contribution multiplied by the ordinary income tax rate.
8. Out-of-Pocket Cost: An apples-to-apples end result, for fairly comparing various Donation Types. In this illustration, it’s the DAF Contribution + Tax Due – Tax Benefit.

Contributing Cash to a Donor Advised Fund

We’ll start with a cash contribution scenario to serve as a baseline for the rest of our illustrations:

Assuming we allocate $500,000 to the DAF, we can reduce the donor’s AGI by the full amount (whether in the year given, or carried forward over time). If we presume a 37% tax bracket, we can figure a tax savings of $185,000. Therefore, our charitable contribution’s out-of-pocket “cost” is $315,000.

Contributing Unsold Stock to a Donor Advised Fund

As simple as cash contributions may be, it’s often better for all concerned if you donate stock outright as an in-kind (unsold) transfer to a DAF. You then direct the DAF to sell the shares (or keep the shares if you’d like), with no taxes due on the gain.

We covered this in What is a Donor Advised Fund and Why You Might Want to Donate Low Basis Stock. In How to Coordinate a Donor Advised Fund and Your Equity Compensation, we also explored how not all stock shares make for equally ideal donation types. As touched on above, that’s in part because each stock lot, or tranche of stock you own, is likely to have different cost bases and holding periods:

Cost Basis: It’s often better to donate shares with a low- versus high-cost basis. All else being equal, this helps you remove more unrealized capital gains from your income tax by having the DAF sell them instead of you. (If you’re donating shares that originated from an incentive stock option exercise and hold, it’s important to track each share’s regular and AMT cost basis.)

Holding Period: The IRS classifies stock into short-term (S/T) capital gain stock held for 1 year or less, and long-term (L/T) capital gain stock held for more than 1 year. If you contribute S/T stock, the tax deduction is equal to the lesser of the fair market value (FMV) at contribution or the cost basis of the stock. L/T stock allows a tax deduction equal to the stock’s fair market value on the day of contribution.  All else equal, L/T stock is better to contribute than S/T stock.

Examining How Share Lots Can Matter a Lot

Using our chart to illustrate, we can now explore various options for funding a DAF:

1. Giving low basis L/T stock directly to the Donor Advised Fund as stock shares
2. Selling low basis L/T stock and donating the after-tax proceeds to the Donor Advised Fund
3. Selling low basis S/T stock, and donating the after-tax proceeds to the Donor Advised Fund
4. Giving low basis S/T stock directly to the Donor Advised Fund as stock shares

Examining this chart, we can observe the following:

Donation Type 1: Donating the low-cost basis shares directly to the DAF does the best job at maximizing your charitable contribution, and minimizing your out-of-pocket cost. Compared to the next lowest out-of-pocket cost from Donation Type 2, this strategy reduced out-of-pocket cost by an additional $36,260.

Donation Type 2: Selling L/T shares and giving the after-tax proceeds to charity is the next-best scenario, but the charity receives less than if the shares were donated in-kind. From an efficiency standpoint, it’s unlikely you’d want to sell the stock, pay the tax, and give the after-tax amount if you could give the shares direct.

Donation Type 3: Selling S/T shares and donating the after-tax cash to charity is the next best option when considering out of pocket costs. However, the charity, in this scenario, receives the least ($318,700), as you need to pay $181,300 in tax as part of the short-term sale of stock.  The taxable benefit of the $318,700 donation is $117,919.

Donation Type 4: Contributing S/T shares directly ensures the DAF receives the full value of the stock.  However, your tax benefit is lower. As described above, the deduction on a charitable contribution of short-term capital gain stock is the lower of the FMV at contribution or the cost basis. In this example, that would be the cost basis, calculated as follows:

Cost Basis x Tax Rate = Tax Savings

$10,000 x 37% = $3,700

The total out of pocket cost is equal to $500,000 (the value of the donation to charity) less $3,700 (the tax benefit of the donation), or $496,300.  Easily the highest out of pocket cost.

Next Up: From Where Did Your Equity Compensation Originate?

So, what do we know so far?

• L/T vs. S/T: Clearly, there are benefits to contributing long-term vs. short-term capital gains stock to charity.
• Low vs. High Basis: Shares with a low basis are almost always preferred over high basis holdings.
• Cash vs. Shares: When donating to a DAF, cash isn’t necessarily king. Directly donating low basis, long-term shares will usually reign supreme.

With this understanding, we can now explore the impact different types of equity compensation can have on your taxes and charitable contributions alike. We’ll take that on in part 2. Stay tuned!