When a business owner decides to sell their business, they often face substantial capital gains taxes on the proceeds from the sale. However, for those who are philanthropically minded, there is a strategy that can mitigate these taxes while also contributing to the community: donating a portion of their interest in the business to a community foundation. This approach not only offers significant tax benefits but also allows business owners to support causes they care about. This article will explore why and how a business owner can donate a portion of their interest in their business to a community foundation as part of the strategy of selling their business.

Understanding Capital Gains Taxes and Charitable Contributions

When a business is sold, the difference between the selling price and the original purchase price (the basis) of the business is considered a capital gain. This gain is subject to capital gains tax, which can be a substantial percentage of the sale proceeds, particularly for businesses that have appreciated significantly over time. In the United States, the federal capital gains tax rate can be as high as 20%, and with state taxes added, the total tax burden can be even higher.

However, the IRS allows for charitable contributions of appreciated assets, such as interests in a business, to be made to qualified charitable organizations, including community foundations. When such a donation is made, the donor can claim a charitable deduction for the fair market value of the donated interest and avoid paying capital gains taxes on the appreciation of the donated portion.

The Benefits of Donating to a Community Foundation

Community foundations are public charitable organizations that support a wide range of local philanthropic efforts. They manage individual charitable funds set up by donors and make grants to support local nonprofits and community projects. Donating to a community foundation offers several advantages:

  1. Tax Deduction: Donors can claim a charitable deduction for the fair market value of the donated business interest. This deduction can offset other taxable income, thereby reducing the overall tax burden.
  2. Avoidance of Capital Gains Taxes: By donating a portion of the business interest before the sale, the donor avoids capital gains taxes on the appreciated value of the donated portion. This can result in significant tax savings.
  3. Philanthropic Impact: Contributions to a community foundation allow business owners to support causes they care about in their local community. The foundation's expertise ensures that the funds are used effectively and in alignment with the donor's philanthropic goals.
  4. Professional Management: Community foundations provide professional management of charitable funds, ensuring that the donated assets are invested and granted in a way that maximizes their impact.

How to Donate Business Interests to a Community Foundation

The process of donating a portion of business interest to a community foundation involves several steps:

  1. Planning and Consultation: Business owners should start by consulting with their financial advisors, tax professionals, and legal counsel to understand the implications of donating business interests and to develop a strategic plan. They should also contact the community foundation to discuss their intentions and ensure that the foundation can accept the donation.
  2. Valuation of the Business Interest: An independent, qualified appraiser must determine the fair market value of the business interest to be donated. This valuation is essential for calculating the charitable deduction and ensuring compliance with IRS regulations.
  3. Transfer of Interest: The business owner transfers the agreed-upon portion of the business interest to the community foundation. This transfer must be executed before the sale of the business to ensure that the donation qualifies for the intended tax benefits.
  4. Sale of the Business: After the transfer is complete, the business can proceed with the sale. The community foundation will hold the donated interest and receive the proceeds from its share of the sale.
  5. Charitable Deduction: The business owner claims a charitable deduction for the fair market value of the donated interest on their tax return. This deduction can offset other income and reduce the overall tax liability.
  6. Grantmaking and Legacy: The community foundation sells its interest to the purchasing party and uses the proceeds to establish a donor-advised fund or other type of charitable fund.
  7. Fund and Grant Management: The community foundation manages the proceeds from the sale of the donated business interest and makes grants in accordance with the donor's philanthropic wishes. This creates a lasting legacy that benefits the community.

A Practical Example

Consider a business owner who owns a company valued at $5 million, with an original purchase price (basis) of $1 million. If the owner sells the business without making any charitable donations, they will face capital gains taxes on the $4 million gain.

However, if the owner donates a 25% interest in the business to a community foundation before the sale, the tax situation changes significantly. The owner would transfer a $1.25 million interest to the community foundation (25% of $5 million). The charitable deduction for this donation would be $1.25 million, which could be used to offset other taxable income.

When the business is sold, the community foundation receives 25% of the sale proceeds, amounting to $1.25 million. The owner avoids paying capital gains taxes on the $1 million gain associated with the donated portion (25% of the $4 million gain). This results in substantial tax savings and provides significant support to the community foundation.

Key Considerations and Potential Challenges

While donating business interests to a community foundation offers substantial benefits, it also involves several considerations and potential challenges:

  1. Complexity: The process can be complex and requires careful planning and execution. Business owners should work with experienced professionals to navigate the legal, tax, and financial aspects of the donation.
  2. Valuation Issues: Accurate valuation of the business interest is crucial. Over- or under-valuation can lead to IRS scrutiny and potential penalties.
  3. Timing: The donation must be made before the sale of the business to qualify for the tax benefits. This requires careful timing and coordination with the sale process.
  4. Foundation Policies: Not all community foundations may be equipped to accept donations of business interests. Business owners should ensure that the chosen foundation has the capacity and policies in place to manage such donations.

Conclusion

Donating a portion of business interest to a community foundation as part of the strategy of selling a business can offer significant capital gains tax benefits while also supporting local philanthropic efforts. This approach allows business owners to maximize the impact of their charitable giving and leave a lasting legacy in their community. By working with financial advisors, legal counsel, and community foundation professionals, business owners can navigate the complexities of this process and achieve both their financial and philanthropic goals.

If you are considering incorporating philanthropy into the sale of your business, the Community Foundation of North Central Massachusetts can help. Contact Erin Thomason (ethomason@cfncm.org) or Stephen Adams (sadams@cfncm.org) or visit us at www.cfncm.org. 

Note

The information provided here on the tax benefits of philanthropy is for general informational purposes only and is not intended to be legal, tax, or financial advice. While we strive to provide accurate and up-to-date information, the application of tax laws can vary based on individual circumstances, and tax laws may change.

We strongly recommend that you consult with a qualified tax advisor, accountant, or legal professional before making any decisions or taking any actions based on the information provided.