Early Charitable Planning Is a Profitable Virtue

Charitable donations of real estate, partnerships and privately held businesses can turn tax savings into impactful philanthropy, but the IRS may unwind the benefit if donations are made too late. Early planning is key.

By Jeremy Pearl, Executive Vice President and Chief Financial Officer and Ollie Benn, Director of Philanthropy and Social Impact

Time is not always on our side. We have seen entrepreneurs and investors fall into a potential trap when a liquidity event approaches or a great offer appears. Suddenly they and/or their advisors see a wonderful opportunity to make a charitable contribution and avoid capital gains. Understandably, donors may want to wait until right before a transaction closes to gift an asset to charity. But waiting too long can cause the IRS to argue that the gains were taxable back to the donor even if the transaction is not yet consummated, which could cause a huge tax bill.

Let’s say you own a business or invested in some real estate. The asset’s value has risen substantially over time. You begin negotiations with a potential acquirer. And you start thinking about what to do with your gains.

You know that the government has its eyes on those potential capital gains. You also know that donating a portion of the assets (whether private stock or real estate interests) to charity can have big tax advantages. You can typically avoid capital gains tax on the appreciated assets being donated and take a deduction for the fair market value of the asset (subject to valuation discounts in some cases). This can lead to huge potential tax savings.

And there’s a natural temptation to wait until the last moment before the liquidity event to donate the assets. Your thinking is: (1) I get the maximum asset value by waiting until the last minute; (2) the valuation is more certain at that point; and, (3) if for some reason the deal falls through, I may want to re-think the donation.

But that’s where the IRS may argue that you’re trying to have your cake and eat it too. As far back as the 1970s, case law led to an IRS Ruling putting taxpayers on notice that, when a charitable gift is followed by a “prearranged plan,” the IRS will “treat the proceeds as income to the donor” if the charity is legally bound (or can be compelled) to sell the property.

Consider these examples:

1. Sarah owns a condo that she has rented for many years. It is fully depreciated, and she no longer needs the rental income. She had been considering making a testamentary gift of the property to her favorite charity by naming them a beneficiary in her trust. However, when she was approached by a real estate agent with a plan to market the property for a far higher price than she anticipated it was worth, she signed a listing agreement with the agent. Excited by the prospect of making a major gift, she approaches the charity to give them the good news and offers to deed the property to them prior to the sale. Will Sarah avoid recognizing gain on the sale if the property is transferred before a buyer is identified?

2. Eli is a shareholder and early investor in a local, privately held biotech company. The company agrees to accept an all cash buyout offer from a publicly traded company and they notify shareholders of the pending transaction and request their approval. Eli signs the shareholder consent and immediately calls his local community foundation, so that he can transfer the stock to his donor advised fund prior to the completion of the transaction. Will Eli avoid recognizing capital gain once the shares are redeemed, even if they were transferred to the foundation prior to the completion of the transaction?

3. Josie is a limited partner in a large real estate partnership that holds an apartment building. The partnership agreement provides for income distributions to investors, and her interest is illiquid. The general partner informs the limited partners that they plan to sell the apartments and that they will offer the limited partners either (a) an opportunity to redeem their interest for cash, or (b) the ability to “rollover” their investment by participating in the partnership’s planned Section 1031 exchange, allowing the partnership to defer any gain due on sale by purchasing a new apartment property. Josie had always planned to gift her interest to charity but wanted to wait until she was able to redeem her interest for cash. Can she avoid any gain by quickly gifting her interest?

This issue is particularly challenging because there’s room for interpretation. The tax consequences can be substantial if the IRS decides the donor had effectively retained control of the property.

For that reason, it makes sense to start planning with financial advisors and the intended charitable beneficiary as far ahead as possible. It can take weeks or longer for all parties to run projections, conduct due diligence and prepare a gift agreement.

Having worked so hard to achieve the liquidity event, it makes sense to maximize the charitable impact and tax savings. The Jewish Community Foundation designed a “complex gifts” acceptance process to ensure that donors, their advisors, the Foundation, and beneficiary nonprofits are aligned. Our goal is to partner with the potential donor and their professional advisors to start the process early enough so that philanthropic and financial goals are optimized to the maximum extent allowed under the law. We love to brainstorm and would be honored to be part of YOUR team!

To reach Jeremy Pearl, please email jeremy@jcfsandiego.org. To reach Ollie Benn, please email ollie@jcfsandiego.org. Or call (858) 279-2740.