Illiquid stock options

The economic climate over the past couple of years—with fewer individuals owning highly appreciated stock—has encouraged donors to consider contributing assets other than publicly traded securities and cash to their favorite charities.

For professional advisors with clients who have these unusual assets, determining the most tax efficient and advantageous way to make these contributions can be challenging. This article discusses income tax considerations options donating illiquid securities to a charity. It is the first issue of a three-part series discussing charitable gifts using unusual assets. Some of the more common gifts of illiquid securities include stock of closely held corporations and S corporations, restricted stock, and certain stock options.

Code Section e 1 provides that the deductible amount for a contribution of property is the value of the stock, reduced by i the amount of gain that would not have been long-term capital gain if the property had been sold at its fair market value options ii in the case of a contribution to or for the use of a private foundation, the amount of gain that would have been long-term capital gain if the property had been sold at its fair market value.

Accordingly, when a donor contributes capital gain property, property that may or may not be illiquid and has been held for over a year, to a public charity, the donor can take a charitable income tax deduction for the donation based on its fair market value, which includes any appreciation of the asset, and can avoid tax on the capital gain.

Code Section e 5 defines qualified appreciated stock as stock of a corporation for which market quotations are readily available on an established securities market, and which is a long-term capital asset. Even if the stock donated is qualified appreciated stock, if the total amount of stock contributed, including all past contributions, stock ten percent of all of the outstanding stock of the corporation, the donated stock in excess of ten percent of the value of the illiquid stock will not be considered qualified appreciated stock.

Securities held for less than one year may also be donated, but the deduction is limited to the lesser of cost basis and fair market value. Individuals who own interests in closely held corporations, i. Giving stock of a closely held corporation requires careful planning. A key concern for the donor who gives stock of a family-owned or other closely held corporation to a charity may be having an outsider who is not related to the other owners as a stockholder.

In addition, the charity generally has no desire to be saddled with illiquid securities. In this type of transaction, the donor can take a deduction equal to the fair market value of the contributed stock.

Assuming the stock has appreciated in value, the donor will not have to recognize the appreciation as gain. The contribution and redemption must occur without any sort of prearrangement between the donor and the charity. Failure to structure the gift properly will convert the transaction into a sale of the stock by the donor with a corresponding tax on the gainfollowed by a gift to charity of the proceeds.

In addition, donors who are shareholders of corporations that are contemplating termination, liquidation, or merger should consider contributing all or part of their shares prior to any formal decision. This timing avoids income tax on the gains allocable to the contributed shares, effectively providing for charity out options pre-tax dollars.

Donors may instead consider donating to a public charity, such as a community foundation, which is stock subject to the private foundation excise taxes. If a redemption or sale of the stock is impractical, a donor can effectively control contributed stock through the use of a Charitable Remainder Trust CRTa trust in which the income first goes to beneficiaries for a term and the principal then goes to charity.

CRTs allow a deduction upfront calculated by reference to the present value of capital gain property donated to a public charity with the same five year excess deduction carry forward.

When the assets can be sold, the donor can avoid capital gain taxes. Donors using CRTs should be aware that the various federal tax rules that apply to private foundations also apply to CRTs. A Charitable Lead Trust CLTa trust from which the income is first donated to a charity, and then, after a specified period of time, the principal is distributed to individual beneficiaries, may not be as appealing as a CRT, but it may provide some planning opportunities for certain donors.

In the grantor form of the CLT, in which income, deductions, gains, and losses are all contributed to the donor, he can take an upfront charitable deduction. In the more common nongrantor form of the CLT, the trust is taxable on its income and takes a deduction for amounts distributed to charity.

In both forms, the income or gains are fully taxable to the donor or the trust itself. The CLT lets the donor maintain greater control over the contributed stock and, in the non-grantor form, may be useful for a donor trying to reduce or eliminate transfer or estate taxes in transferring the remaining amount of the trust to his heirs. As with CRTs, donors using CLTs should be aware that the private foundation rules generally apply to CLTs, with certain exceptions.

Philanthropic opportunities are also available for owners of so-called S corporations. These small businesses operate as corporations, but are treated as partnerships for tax purposes. They have a maximum of shareholders and only certain people are eligible to become shareholders.

Generally, S corporation stock is treated much like closely held stock, with a few significant differences. When evaluating a gift to charity, a donor of S corporation stock should be aware of the types of assets held by the corporation, especially appreciated inventory or unrealized receivables. All items of income and gain passed through to the charity during the period that it holds the S corporation stock will constitute unrelated business taxable income.

As a result, the value of the S corporation stock to the charity can be effectively diminished by the amount of tax liability that the charity must bear. Although a charity may hold S corporation stock, the tax law currently prohibits CRTs and some CLTs from holding S corporation stock the grantor form of the CLT may hold S Corporation stock.

The transfer of S corporation stock to a CRT or certain CLTs will automatically terminate the S corporation status of the corporation, and make it taxable as a C corporation. Instead of an individual owner donating S corporation stock, the S corporation itself can donate assets to charity.

The gift is treated as if made on a pro rata basis by the shareholders and is subject to their individual contribution limits. The charitable deduction that a shareholder can take is limited to the basis in her shares. Deductions that are unused because of this basis limitation may be carried forward indefinitely. These restricted securities usually trade at a discount in relation to freely traded securities because of the restrictions.

Restricted stock can be donated to public charities in much the same manner and can often produce the same tax consequences as closely held stock discussed above. But donating restricted stock raises additional issues in determining the amount that a donor can claim as a charitable deduction. The IRS has ruled privately that stock subject to Rule i.

The ruling also noted that the value of the stock was less than the value listed on the established securities market because it was subject to resale restrictions. Private Letter Ruling In a ruling involving a contribution of stock subject to Rule volume restrictions to a private foundation, the donor agreed to restrict his own sales so the volume restriction would not apply to prevent a private foundation from selling the shares, and the IRS held the stock was qualified appreciated stock, deductable at fair market value.

The IRS found that the restricted stock could be considered qualified appreciated stock because the shares that the foundation received would be freely transferable immediately upon receipt as a result of the agreement between the donor and the foundation. A donor should consult with a tax advisor to determine whether a full fair market value deduction is appropriate for a contribution of restricted stock to a public charity or a private foundation. To the extent that the restricted stock requires the charity to make certain representations as a new investor before the donor can contribute the stock, the donor should ensure that the charity can make such representations.

Instead of contributing stock itself, a donor can contribute stock options, rights to buy or sell shares of stock at a guaranteed price during the life of the option.

Before donating options, a donor options first review the terms of the option plan to determine options an option transfer is even possible.

A living donor cannot donate incentive stock options ISOswhich are a type of employee stock option granted only to employees and which confer a significant tax benefit.

If the option plan permits, the ISOs can be given as a bequest, which would generate a charitable deduction for the estate. Alternatively, a donor can exercise the ISOs and give the ISO shares as an inter vivos gift. If the donor has held the shares for the requisite holding period,4 she can claim a fair market value deduction and avoid recognition of any capital gain.

Notably, with this type of gift, Alternative Minimum Tax AMT concerns may arise and a donor should review her tax situation to determine whether the AMT will apply. On the other hand, a donor can transfer nonqualified stock options NSOswhich are options granted to employees or service providers to purchase shares of stock at a fixed price, during his lifetime. NSOs generally do not have a readily ascertainable value at the date of grant, and the employee or service provider will be subject to tax only at the time of exercise even if donated to a charity.

Donating NSOs can be problematic, however, because NSOs generally generate income to the donor upon exercise, and a possible timing difference exists between the recognition of income and the completion of the gift for purposes of the charitable contribution deduction.

Because the donor may not know exactly how much income he will recognize or the value of the charitable deduction, it may be better for the donor to first exercise the NSOs and then donate the proceeds to charity.

If instead the donor donates the shares received from exercising an NSO, he will be allowed a charitable deduction that can be used to offset the income recognized at exercise. Because of the complexities involved in contributing stock options, donors should consult with their tax advisors to determine the most tax-effective way to make such donations. In order to claim a deduction for contributing any of these illiquid securities, a donor must substantiate the contribution with a receipt from the charity showing i the name of the charity; ii the date of the contribution; and iii a reasonably detailed description of the property.

A qualified appraisal must be made by a qualified appraiser in accordance with generally accepted appraisal standards, and must meet the relevant requirements of Section 1. A qualified appraiser is an individual who has either earned an appraisal designation from a recognized professional appraiser organization or has met certain minimum education and experience requirements.

For appraisers of property other than real property, the appraiser must have successfully completed college or professional-level coursework relevant to the property being valued, have at least two years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and fully describe in the appraisal her qualifying education and experience. The individual must also regularly prepare appraisals for pay, and must not be prohibited from practicing before the IRS at any time during the three year period ending on the date of the appraisal.

The donor, the donee, or the taxpayer who claims the deduction is not a qualified appraiser with respect to the contribution. The appraisal may not be made earlier than 60 days before the date of contribution of the property, and no part of the fee arrangement can be based on a percentage of illiquid appraised value of the property.

Stock separate appraisal is needed for each item of property that is not included in a group of similar items of property. If the donor does not attach the appraisal, she cannot deduct her contribution, unless the failure to attach the appraisal is illiquid to reasonable cause and not to willful neglect. Donors should also be mindful of the timing requirements that exist as to when the appraisal should be received and when it should be claimed on a return.

When the IRS reviews a return with a gift requiring an appraisal, it may accept or dispute the appraisal. Donors may be liable for a penalty if they overstate the value of donated property. A donor cannot take a charitable deduction for fees that she paid for appraisals of the donated property.

Still, these fees may qualify as a miscellaneous deduction, subject to the two percent limit if they are paid to determine the amount allowable as a charitable contribution. The charity should not pay for the appraisal unless it illiquid show the cost of the appraisal as consideration received for the gift.

If the gift is to a donor-advised fund or a supporting organization, the charity may not pay the appraisal fee. Gifts are valued as of their date of gift, usually indicated by recent arms-length sales. Unfortunately, this information is rarely available for these types of stock. Accordingly, valuing illiquid securities is often quite difficult and subjective, making the valuation process more art than science.

Appropriate discounts for lack of marketability, minority interests, illiquid other factors are then applied to establish the fair market value of the stock. In terms of valuing restricted stock, the process is typically more involved than valuing the underlying publicly traded stock, and the qualified appraisal will likely take into account the nature and duration of the restrictions.

To arrive at fair market value, the appraiser or the donor, if a qualified appraisal is not required, will consider certain factors, including the resale provisions found in the restriction agreements and the market experience of freely traded securities of the same class as the restricted options. The IRS recommends that donors keep complete financial and other information on which the valuation is based, including copies of reports on the company made by accountants, engineers, or any technical experts on or close to the valuation date.

Donors and charities must consider a number of issues when making and accepting gifts of illiquid securities, including the timing and valuation of the gift, potential tax liabilities, and any restrictions on subsequent sale or disposition of the stock. The New York Community Trust, because of its flexible structure and knowledgeable staff, is well positioned to handle these gifts. For further reference, see: Footnotes 1 All references to the Code are to the Internal Revenue Code ofas amended, options all Regulation Section references are to the regulations promulgated thereunder.

Donating the depreciated stock would not allow the donor to take a deduction for illiquid loss; instead, the donor could only take a charitable deduction for the value of the stock.

Accordingly, donors who set up these types of funds at community foundations should also be mindful of these rules.

A three month employment requirement also has to be satisfied prior to exercise. See Code Section a 2. WiltonGeneral Counsel and A. Nicole Spooner, Associate General Counsel of The New York Community Trust.

This stock was developed by The New York Community Trust for the use of professionals. It is published with the understanding that the publisher is not rendering legal, accounting, or other professional advice.

Contact Gay Youngvice president of donor services, at x MyNYCT Login Newsroom Resources Contact Us. About The Trust Overview Video: Overview Create Your Own Charitable Legacy Why Donors Choose The Trust How to Set Up a Fund Types of Funds Planned Gifts and Wills How We Invest Grant Results.

The Heart of The Trust How to Manage Your Fund Honoring Our Donors Donor Events Donor FAQs MyNYCT Login Annual Fund. Grant Seeker Overview Guidelines for Grant Seekers Grants at Work Requests for Proposals. Gifts of Illiquid Securities Some of the more common gifts of illiquid securities include stock of closely held corporations and S corporations, restricted stock, and certain stock options.

Stock of a Closely Held Corporation Individuals who own interests in closely held illiquid, i. Stock of an S Corporation Philanthropic opportunities are also available for owners of so-called S corporations. Private Letter Ruling In a ruling involving a contribution of stock subject to Rule volume restrictions to a private foundation, the donor agreed to restrict his own sales so the volume restriction would not apply to prevent a private foundation from selling the shares, and the IRS held the stock was qualified appreciated stock, deductable at fair market value.

Private Letter Ruling A donor should consult with a tax advisor to determine whether a full fair market value deduction is appropriate for a contribution of restricted stock to a public charity or a private foundation. Stock Options Instead of contributing stock itself, a donor can contribute stock options, rights to buy or sell shares of stock at a guaranteed price during the life of the option.

Substantiating the Gift In order to claim a deduction for contributing any of these illiquid securities, a donor must substantiate the contribution with a receipt from the charity showing i the name of the charity; ii the date of the contribution; and iii a reasonably detailed description of the property. Special Considerations in Valuing Stock of Closely Held Corporations S Corporations and Restricted Stock Gifts are valued as of their date of gift, usually indicated by recent arms-length sales.

Conclusion Donors and charities must consider a number of issues when making and accepting gifts of illiquid securities, stock the timing and valuation of the gift, potential tax liabilities, and any restrictions on subsequent sale or disposition of the stock. IRC Section b 1 A: General rule for percentage limitations for individuals. IRC Section e 5: Special rule for contributions of stock for which market quotations are readily available.

IRC Section e: Special unrelated business income rules applicable to S corporations. Rules governing S corporations. Taxes on excess business holdings. Taxation of nonqualified stock options. Value of a contribution in property. Charitable contributions of property. Limitations on deduction of pass-through items of an S corporation. Valuation of stocks and bonds.

Effect on earnings and profits. Revenue RulingCB Revenue RulingC. Commissioner, F3d 4th Cir. Determining the Value of Donated Property. NoticeI. For more information call Jane L. Wilton, general counsel, at Questions about setting up a fund? Overview Why Rely on Professional Grantmakers?

Professional Advisor FAQs Grant Seeker FAQs. Why Clients Trust The Trust Nicole Francis: Types of Funds Investment Vehicles Administrative Fees. Gifts of Closely Held Business Interests What Happens When a Charity Goes Broke Estate Planning for the Non-Taxable Estate Charitable Giving Update: Topics of Note in Terminating a Private Foundation Changing a Private Foundation's Status Changing Course: Early Termination of CRTs State Governance Reform for Nonprofits Investment Standards for NY Charitable Trusts Investment Standards for NPs Under NYPMIFA Endowment Spending Under NYPMIFA Charitable Gifts of Publicly Traded Securities Donating Mutual Fund Shares to Charity Timing of Charitable Contributions Unusual Charitable Gifts Contributions of Art Charitable Gifts Using Illiquid Securities Gifts of Interests in Pass-through Entities Charitable Gifts of Real Estate.

Sign Up for E-News. MY NYCT LOGIN BOARD LOGIN. The New York Community Trust. INDEX Stock of a Closely Held Corporation Stock of an S Corporation Restricted Stock Stock Options Substantiating the Gift Valuing the Gift Conclusion and Footnotes.

Employee Stock Options Explained