Many people who made money working at a startup want to give back. Here are some of the common ways people give money to charities and some of the different vehicles you can use for your philanthropic efforts.
Charities in the United States and tax deductions
Charities in the United States are almost all organized under Section 501(c)(3) of the Internal Revenue Code, which means they don’t have to pay most forms of federal income tax. To qualify to be exempt from taxes, an organization must be charitable, religious, educational, scientific, or similarly qualified.
Further, donations to qualified 501(c)(3) organizations are eligible to be deducted from the donor’s income for tax purposes. Thus, taxpayers are incentivized to make donations to charities as this can lower their taxes. Also, because of the tax-exempt status of qualified organizations, they frequently play a part in tax minimization planning.
Here is an illustration of how charitable donations reduce a donor’s income tax.
A single filer donor’s income for the year is $900,000; if they do not make donations, they will be paying federal income tax on the full $900,000, coming out to about $295,000, or 33% of the $900,000 gross income. However, if they make $250,000 of donations to qualified organizations, they will only have to pay tax on the remaining $650,000, as they get to deduct the donations from their taxable income. Income tax on the $650,000 would only be about $205,000, which is only 23% of the $900,000 gross income. Taxes go from $295,000 to $205,000. However, the donor also has $250,000 less of assets as well, so while they saved $90,000 of taxes, they have $160,000 less money overall. Do not pursue this strategy unless you really want to give money away.
How much should I give?
Choosing how much to give to charitable causes is a decision that will be different for everyone. Most donors use these factors to determine their amount of giving:
- Their philosophical affiliation and recommendation - many religions recommend a 10% tithe
- Current life prosperity (Are you particularly comfortable or scrimping and saving?)
- Gut feeling (Does 10% seem too little or too much?)
- Needs of their favorite organizations (Does one charity require $25k for a special purpose this year?)
- Refining over time (How can you improve your back-of-the-envelope calculation?)
What should I give — cash or stock?
From a tax and financial perspective, the thing you as an individual (or revocable trust holder) want to be giving away to charity is long term, low basis, public company shares. Breaking that down more:
Long term: You need to have owned the asset you are donating for over 12 months (the special benefits don’t work if your holding period is less than a year)
Low basis: Basis is your acquisition cost for tax purposes. The goal is to donate the assets with the largest percentage unrealized capital gain (market price over purchase price). Usually, the shares you acquired earliest are the lowest basis shares.
Public: Listed on NASDAQ or NYSE; many charities can only accept stock gifts if they can sell them for cash right away
Shares: Shares are the donatable unit, not options. Employee based option contracts are generally non-transferrable and written so that transfers to a charity would not work
This gifting strategy is more tax efficient than selling your company's stock (which creates a taxable event for you), then donating the remaining cash to your charity. Reducing the tax friction around a gift effectively makes the gift larger. By donating long term, low basis, public company shares, you can avoid having to pay capital gains tax on the appreciation in the donated shares, and in addition you can deduct the donation from your income.
Transferring the shares directly is called transferring “in-kind.” The charity then sells the stock donated “in-kind” for cash and can use the funds like they would a cash contribution. The low cost basis carries over to the charity, and normally the charity would owe capital gains tax after the sale on their realized gain. However, qualified charities are generally exempt from capital gains taxes, so you are able to save the ~20-40% in taxes you would owe if you sold under your name and then donated the cash.
Direct to charity
Most qualified charities can receive an in-kind gift of exchange traded stock. If the charity cannot accept a gift of stock in-kind, you can:
- gift cash directly (inefficient, but acceptable for small donation amounts)
- route the donation through a specially designed charitable fund called a “donor-advised fund” (useful for gifting $10,000+)
- make use of a private foundation (preferred for larger or recurring gifts).
If your stock is not traded on a public exchange, your options are more limited. Some charities will accept private illiquid stock, but many will not. You likely can transfer it to a private foundation, but that has additional complications.
Roughly, the size of the charitable gift determines its preferred form. If the charitable gift is:
- Less than $1,000, cash is probably the best form.
- $1,000 to $10,000 could be cash or stock, (or preferably cash from a donor-advised fund).
- Above $10,000 should be made in long term low basis stock if you have it. Gifts of $10,000+ generally should be made directly to the charity in-kind or in-kind to your donor advised fund or private foundation. The donor advised or foundation then sells the shares received and sends cash to the charitable organization.
Your income tax deduction will depend on the recipient (public charity or private foundation) and the form of the gift (cash or in-kind). Under non-CARES Act years, maximum annual deductions range from 20% for in-kind gifts to private foundations to 60% for cash contributions to public charities. If you cannot use all of your donation deduction in one year, you can carry it forward for up to five years.