Investors in start-up companies, so-called “angel investors”, have unique opportunities and challenges in using their angel investments for their charitable giving. Giving angel investments to charity rather than more liquid assets can have significant benefits for the angel donor. However, donating illiquid, hard to value assets must be done carefully with a close eye on the unique tax treatment of illiquid securities, as well as working together with the charity on receiving the gift appropriately.
Benefits of Giving Angel Investments to Charity
- Low impact to the donor’s cash flow
- Potentially larger charitable deduction than the amount of your capital investment (appreciated value might be the value of the gift)
- Avoidance of Capital Gains Tax
- Deduct full fair market value against your income
- Possible enormous impact to the charity
As with any gift of securities to a public charity,1 you can deduct the full fair market value of the asset being donated, for a deduction of up to 30% of your income.2 As a result, if a stock or membership interest in an LLC has a large unrealized, long-term capital gain, the tax benefit to the donor is even larger because any realization of capital gain is the responsibility of the charity when the charity sells the security interest.
Even if an angel investment does not yet have a large capital gain, an angel donor might have several non-tax related reasons for donating an angel investment. A donor might want to minimize the impact of a charitable gift on the donor’s net worth or cash flow; or to engage a charity in a possible game-changing investment in which the charity and donor’s interests are aligned.
A large capital gain is the hope of every angel investor and making a gift of an angel investment in that context benefits the donor and charity significantly.
Complications of Giving Angel Investments to Charity
- Limitations on entities that may own stock or membership interests
- Not all charities accept closely-held or restricted stock
- Unique treatment for pass-through tax entities and Rule 144 stock
- A qualified appraisal is required and can be expensive
Limitations on Ownership of Angel Investments
As any angel investor knows, there are several layers of restrictions on who may own stock or membership interests in particular companies. Some investments require “qualified investors” while others may limit investors to a certain class, such as a particular group of individuals or entities. And, to further complicate matters, these restrictions may change depending upon the round of investment.
Before any angel donor makes a gift to charity, he or she (perhaps with the assistance of the charity’s legal counsel) must determine if the charity is a permissible owner or “transferee” of the interest. Is the recipient charity included in the class of possible owners? Does the charity qualify as an owner under the applicable rules? These are threshold questions that need to be answered by the donor.
Take away: A donor must review the terms of permissible transferees of any interests being given.
Limitations by the Charity
Charities, and particularly smaller entities, are looking for gifts that they can put to work right away. A gift of an angel investment is by its nature, illiquid until a particular exit event and as a result, most charities are not interested in receiving an illiquid gift with no clear timeline of when it will become liquid. Typically, only the most sophisticated charities, such as larger college endowments, community foundations and large, national non-profits, will accept angel investments as gifts.
Often, it is tempting to make a gift of an angel investment just before a liquidation event for the stock or under a pre-arranged sale of the donated stock back to the angel investor or with a planned redemption of the stock immediately after the gift. However, these pre-arrangements run into significant problems with the IRS. A pre-arranged redemption or sale of the stock or membership interest by the charity will cause the original donation to be treated as a sale for value, resulting in no charitable deduction and the realization of any capital gain.
In addition, the charity will be leery of receiving any asset that might represent “unrelated business income” for the charity. For partnership interests (or s-corp stock), this can be a real problem for the charity.3 These complex tax issues for the charity are often not identified by the charity itself until far along in the process – perhaps even after they have said “yes” to the gift initially.
Take away: An angel donor should insist that the recipient charity’s legal and tax advisors be involved in the gift planning from the very beginning.
Pass-Through Entities
For angel investments that are treated as pass-through entities (such as s-corp stock, partnership interests or LLC interests), there are unique challenges for establishing the accurate value of the gift to the charity. Generally, a shareholder’s fair market value in a pass-through entity is reduced pro-rata by the fair market value of underlying entity’s appreciated inventory and unrealized receivables.4 This tends to diminish the income tax deduction value of the gift to the donor.
Take away: The tax treatment of the entity being donated needs to be clearly identified and considered as part of the value of the gift to the donor and the charity.
Rule 144 Restricted Stock
Sometimes stock is subject to restrictions on sales imposed by the Securities and Exchange Commission, or by agreement among all parties involved. These restricted securities usually trade at a discount in relation to non-restricted securities because of the restrictions. Restricted stock can be donated to public charities in much the same way as non-restricted securities and can offer the same tax benefits to the donor when making the gift.
But donating restricted stock raises serious issues in determining the amount that a donor can claim as a charitable deduction. This is particularly true when restricted stock is given to a private foundation.5 The conclusion in recent IRS statements is that although Rule 144 stock may have a market price, the actual fair market value is something less than the market price, thus reducing the tax deduction.
Take away: When making a gift of Rule 144 stock, you need to consult a tax advisor familiar with the specifics of valuing that stock.
Qualified Appraisal
The IRS generally requires an appraisal made by a qualified appraiser of a gift of property, other than unrestricted, publicly traded stock, valued over $5,000. A donor does not need an appraisal if the property is non-publicly traded stock worth $10,000 or less. Accordingly, only gifts of closely held stock and restricted stock for which the donor claims a deduction of more than $10,000 require a qualified appraisal.
A qualified appraisal must be produced by a qualified appraiser in accordance with generally accepted appraisal standards.6 The appraisal may not be made earlier than 60 days before the date of the gift of the asset, and no part of the appraisal fee arrangement can be based on a percentage of the appraised value of the property.
Take Away: The angel investment being given to charity must be appraised under the specific guidelines of the Internal Revenue Code in order for the charitable deduction to be allowed.
Conclusion
There are significant benefits to the angel donor in making a gift of an angel investment to charity. For the gift to make sense for the donor and the charity, the donor should do the following:
- Seek advice from tax professionals with expertise in angel investments and charitable organizations
- Engage the charity in the planning process from the very beginning
- Discuss and review the gift with the underlying company
With these key factors in mind, an angel donor can be extremely successful in making a huge impact on the charity and reap the tax benefits of the donation.
Footnotes:
1. The public charity must be qualified by the IRS as a 501(c)(3) organization. It is important to note that gifts of appreciated assets to private foundations are treated very differently from gifts to public charities. Gifts of appreciated assets to private foundations are often limited to the cost basis of the asset, not the full fair market value.
2. IRC Section 170. The appreciated stock must also be held for at least one year.
3. IRC Section 170(e).
4. IRC Section 751.
5. Private Letter Rulings 9247018 and 9734034.
6. Treas. Regulation 1.170A-13(c)(3) and Notice 2006-96
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