What are my options for donating…options?
Charitable gifts of stock options and strategies to help offset taxation
Duke University is fortunate to have so many alumni and friends who want to have an impact on this remarkable institution through philanthropy. Many of them are interested in exploring creative and tax-efficient ways to support Duke, and we regularly receive gifts of all sorts of assets.
Last month in Blueprints, my colleague Phil Buchanan discussed gifts of stocks, bonds, mutual funds and other securities. In this post, I’ll discuss a related asset – stock options received from an employer.
There are two types of options that you might receive as part of your compensation:
- Qualified Stock Options, which are often called “Incentive Stock Options” (ISOs); and
- Non-Qualified Stock Options
The rules for each are quite different, including the rules that apply in the context of charitable giving.
For Qualified Stock Options, the charitable avenues are quite limited because these are not transferrable during the life of the option holder.
Non-Qualified Stock Options (NQSOs) are transferrable to a charity in theory, but many option plans will not allow such a transfer, and, even if they do, donors rarely decide to contribute NQSOs because of the way they are taxed.
Generally, employees may be taxed when NSQOs are “granted” by their employer if the value of those options is readily determined. But often that is not the case, so the employee is not taxed upon grant but, instead, when she uses – “exercises” – her NQSOs to purchase stock. At that point, she owes ordinary income tax on the difference between her exercise price and the value of the stock she receives. This is the tax that many people would like to avoid by donating the options to a charity.
Unfortunately, the rules don’t work that way. Instead, if a taxpayer donates her NQSOs to a charity, and the charity exercises them to purchase stock, the taxpayer is still liable for the tax as if she had exercised the options herself.
And the news gets a bit worse: In order to claim an income tax deduction for a gift of NQSOs valued at $5,000 or more, the taxpayer may need to obtain a “qualified appraisal” as defined by the IRS.
But, never fear! Gift planning is here!
The following strategies can help to offset the taxation recognized from exercising NQSOs.
- The simplest strategy is to exercise the NQSOs, sell the stock and then donate those cash proceeds in the same tax year. Though exercising the options will result in ordinary income taxation, the subsequent donation of cash proceeds should help to offset that tax liability.
- Another strategy is a bit more complex but may have greater tax benefits. The taxpayer can exercise the NQSOs and recognize the income tax liability, but offset that tax liability by donating another appreciated asset in the same year. If that donated asset is publicly traded stock owned longer than one year, the donor should receive a tax deduction equal to the fair market value of the stock on the date that Duke receives it. Plus, the donor wouldn’t recognize capital gain on the appreciation embedded in the donated shares because she didn’t sell the stock – she donated it. Duke would sell the stock but wouldn’t owe any capital gains taxes because Duke is tax-exempt. To learn more about donating publicly traded stock, click here.
- A third strategy would be to exercise the NQSOs, recognize the income tax liability and then wait for more than one year after exercising the options. At that point, the taxpayer can donate the stock received from the exercise and claim a tax deduction based on the stock’s value at that time. Because the donation would occur in a different tax year, the income tax deduction resulting from this gift would not directly offset the tax resulting from exercise, but if the taxpayer expects significant tax liability in future years, this may be an effective strategy. As described above, both the donor and the university would avoid taxes on the capital gains built-up in the shares.
When considering these strategies, it may be important to remember that gifts of stock are deductible up to 30% of the donor’s adjusted gross income (AGI), and gifts of cash are deductible up to 60% of AGI. In both cases, any unused deduction may be carried forward for up to five additional years.
The taxation of Incentive Stock Options (ISOs) is quite different — and generally better — than NQSOs: the taxpayer is not taxed upon grant nor exercise. If the taxpayer exercises an ISO and then waits more than one year — and two years since the option was granted — then she’s liable for long term capital gains taxes on the difference between the exercise price and the value of the stock at that point. Taxpayers hoping to avoid that taxation can donate those shares once those two holding periods are met. The taxpayer would receive an income tax deduction equal to the value of the shares on the date Duke receives them.
Please note: ISO planning tends to involve some consideration of the Alternative Minimum Tax (AMT), which is quite complex. So, while we urge you to consult a tax professional about all of the topics discussed in this post – it is particularly important before pursuing a gift strategy involving ISOs.
For more information about charitable gifts of stock options, please contact Duke’s Office of Gift Planning.