How to Coordinate a Donor Advised Fund and Your Equity Compensation

If you have equity compensation and are in an abnormally high-income tax year, it often makes sense to consider how you may be able to offset that pending tax liability. One way to mitigate the tax bill might be to give to charity. Giving to charity in a high-income tax year makes sense for several reasons. First and foremost, the high-income tax year might be the result of cashing out stock, giving you the cash flow necessary to make such a contribution. A high-income tax year may also be an excellent time to donate to charity because the charitable deduction will result in a higher tax deduction due to the higher tax bracket. You are, again, maximizing the value of your contribution.

Equity Compensation and the Impact on Your Annual Income

Your annual income includes the total of your regular wages and your bonus checks, as well as regularly occurring items such as vested restricted stock which will increase your yearly compensation. However, these regular events often do not necessitate a change in economic thinking or financial strategy.

If you have significant additional equity compensation, however, the thinking might require further analysis if you find yourself in a calendar year with significant activity (such as the exercise and sale of employee stock options) or a significant change in the price of the stock (such as is possible with an IPO). In these years, your income may increase, and that increase might be directly related to the type of equity you have and the associated tax rules.

For example, RSUs are generally included in taxable income when the shares vest and are no longer subject to a substantial risk of forfeiture.  Tax recognition occurs regardless of whether or not you sell the vested shares. A less common, but potentially more impactful RSU occurrence could be satisfying a double trigger event concurrent with an IPO. In this scenario, it’s possible that many years of vested RSUs could become taxable in one year, creating an unusually high-income year. For executives and others, it is possible that significant stock values could become taxable upon meeting a particular event, such as an EBITDA, share price, or some other metric.

Employee stock options provide more flexibility to control tax as you decide when to exercise the option. If you have non-qualified stock options or stock appreciation rights and choose to exercise them, you have a taxable event that increases your taxable income.

If you exercise incentive stock options, the impact on your tax return depends on what you do next. If you exercise and sell the shares by year-end, a portion of the gain will be taxed as ordinary income. If you exercise and hold the shares past calendar year-end, you will need to make an adjustment for the alternative minimum tax (AMT).

Why A Donor Advised Fund in a High-Income Year

Your marginal tax rate (the rate at which your highest earned dollars are taxed) is primarily determined by your Adjusted Gross Income (AGI) and taxable income. A high AGI often means a higher taxable income, resulting in a higher tax rate, all else being equal. It only makes sense then, particularly in years when your equity compensation has increased your AGI higher, to consider strategies that can help to lower your taxable income and overall tax burden.

When you have a year where your income is unexpectedly high, it may be the perfect year to contribute to a Donor Advised Fund (DAF). Donating to a DAF allows you to enjoy the tax advantages of your charitable contribution in a year when you need it, want it, and can afford it. You can make a significant contribution in a single year, take a corresponding charitable deduction, and dole out the money over time when you find charitable endeavors that best fit your needs.

How Can I Take Advantage of my DAF?

There are several ways you can use your DAF to help you make the most of your equity compensation. In addition to donating cash, you can donate appreciated stock directly to your DAF. Not only do you receive the charitable deduction in the year you donate, thus reducing your taxable income, but your assets can continue to appreciate while inside the DAF on a tax-free basis.

Depending on your tax needs, you may find it beneficial to bundle charitable gifts into a more significant single contribution to your DAF. For example, if you usually donate $25,000 each year to a charity, you may see higher tax savings by donating $250,000 once every ten years. The tax savings from a bundling move may even be more helpful if you have a year with exceptionally high income, like a year where your equity compensation is higher than average or a year where you had unusual income sources. Bundling charitable gifts into one year may also be helpful, given increased standard deduction limits–$25,900 for married filing jointly for 2022, if you typically do not make enough donations to allow for itemizing deductions on your tax return.

What are the Best Shares to Contribute to my DAF?

To get the most benefit from your DAF contribution, it’s essential to consider how much to contribute, as well as which shares to contribute. Generally speaking, the favored shares to donate will be shares eligible for long-term capital gains treatment.

Especially attractive are long-term shares with a low-cost basis, as you’ll benefit from a tax deduction for the total fair market value of the shares. You’ll also avoid having to sell the shares outright and incur a capital gain.

If you have long-term shares that originated from different types of equity compensation, you should pay particular attention as they may all have a different cost basis. For example, you might have long-term shares resulting from vested RSU/RSAs that you never previously sold. Long-term shares might also originate from the exercise and hold of non-qualified stock options. Both types of awards could be excellent assets to donate to charity.

Incentive Stock or ESPP Stock to a Donor Advised Fund

If you have shares of stock that originated from the exercise and hold of incentive stock options or from the purchase of shares from an Employee Stock Purchase Plan (ESPP), you’ll want to take a closer look. First, you’ll want to ensure that any donation to a DAF has met the standard for a qualifying disposition, i.e., holding the shares for at 2 years beyond the grant date and one year beyond the date of exercise (for incentive stock options). If they have not satisfied such holding period, the donation would be deemed to be a disqualifying disposition, creating a potentially unfavorable taxable event.

If you have ISO shares that have satisfied the requisite holding period, you’ll want to pay attention to the regular basis AND the AMT basis (the fair market value of the stock when the ISO was exercised). ISOs with a big spread between a regular basis and an AMT basis may be shares that resulted in your paying AMT. If you donate these shares, you will not receive an AMT adjustment for sale on your tax return, limiting how quickly you benefit from the AMT credit. ISO shares with a smaller spread between the regular basis and AMT basis might have less of an impact on the AMT credit and may be more attractive shares to give. Note that you can’t give unexercised options to your DAF.

As long as the shares being donated are long-term shares, the amount of your tax deduction is the fair market value of the shares donated, up to 30% of your AGI. You can donate cash up to 60% of your AGI. The total charitable benefit of cash and stock donations cannot exceed 60% of your AGI from 2022-2025.

Donor-Advised Funds and Equity Compensation

For those who are charitably inclined, who have higher than usual taxable income, and who are looking to save on taxes, a Donor-Advised Fund (DAF) can be a great way to meet their needs.

However, not all assets are created equally if you want to fund a DAF. First, you should consider the amount you wish to contribute to the DAF. Once you have this in mind, you can explore your stock awards, shares held, and other assets to determine which assets might be the best to give. Often, low-basis stock can be a great gift if you are looking to maximize a gift and mitigate personal income taxes. But even then, you should consider the origin of your low-basis shares.

In reviewing your intentions for the gift, your existing shares, and your tax return, you could likely develop a strategy that maximizes the gift to a charity and maximizes the tax benefits to you. DAFS can be a complex topic, and you’ll want to be careful to make the right decisions about what goes into the fund. Once you put an asset into your DAF, you can’t get it back out, so it’s essential to carefully consider how your contributions and choices will impact your overall financial plan.

Comparing Stock and Cash Contributions

There are many philanthropic benefits for making charitable donations, with the most powerful being a lasting impact and creating a legacy for future generations to enjoy. Along with a lasting legacy, investors receive a tax benefit for donating cash and securities, which can offset an otherwise higher than usual tax bill following a windfall caused by increased equity compensation or restricted shares vesting.

Understanding how different donation strategies can affect your tax situation will make your financial planning much more straightforward and provide peace of mind for your future. Since there are many contribution methods for funding a DAF, let’s use an example to compare donating. Restricted Stock held for more than one year directly versus first selling the shares, paying the taxes on them, and then donating the cash proceeds.

Let’s assume that you are a startup founder who has approximately $3 million worth of Restricted Stock. Via an assumption, we’ll assume that your shares have a cost basis of $100,000, and that the shares have been held for more than 1 year, thus being long term

Excited about your company’s success, you want to use some of your new wealth to give back, and decide to contribute $1 million to a DAF.  You want to know, however, should you donate your shares directly or sell them and pay taxes first before donating the cash proceeds.

The table below compares the two options and their tax implications:

Example Tax Rate: 20% Long-term federal capital gains plus the 3.8% surtax for medicare net investment income

As you can see in our example, there is a significant difference between both the total donation available to charity and the tax deduction. If you donate the stock directly, you avoid a capital gains tax of $214,200 and the DAF receives the full market value of the stock, or $1,000,000.  If you sell the stock and donate cash, you’ll increase your tax bill by $214,200 and the charity will receive less than the $1,000,0000 (assuming you reduce the available amount by the tax due).  In our example, $785,800.

As you can see, for the charitably inclined, donating to a DAF can make a significant impact on your gifting strategy since they enable you to frontload years of tax savings at once.

By choosing to donate your Restricted Stock, you seek to maximize your donation and mitigate a tax bill.

Tying Your Donor Advised Fund to Your Financial Plan

Equity compensation can cause your income to fluctuate drastically. Factors such as shares vesting, companies going public, or exercising options can quickly bring your income to very high levels, which carry profound tax implications.

High-income years can be challenging to navigate since they often complicate personal finances. By understanding how dramatic income swings caused by equity compensation affect your taxes, you will be much better prepared to structure your finances and avoid penalties and excess taxation.

Charitably minded individuals can use tools like Donor Advised Funds to donate their shares in an impactful way and reduce their tax burden simultaneously. If you are interested in donating shares to a DAF, you should ensure they will optimize your tax benefits; otherwise, you may create an unnecessary tax liability.

Always consult your financial advisor before making complex investment decisions.

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.