Your Privately Held Shares Jumped After an IPO. Now It's Time to Consider Taxes.
How a tax-smart gift of IPO stock can benefit entrepreneurs and charities.
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2020 was the most active year for initial public offerings (IPOs) since the 1990s, according to FactSet. Nearly 500 traditional and Special Purpose Acquisition Company (SPAC) IPOs raised more than $170 billion. Analysis by iCapital Network shows that the market capitalization of the average unicorn that went public in 2020 was more than double its previous valuation on the private markets.
This wave of IPO activity is expected to continue into 2021, and the potential gains in share value before or after a company goes public may result in windfalls with significant tax implications for entrepreneurs, executives and early employees. Selling highly appreciated stock could cause you to face substantial capital gains taxes.
One option to help minimize the tax burden is to donate some of your shares — either during or after the lock-up period — to charity. Many charities accept direct gifts of publicly traded shares and donor-advised funds, which are 501(c)(3) public charities, typically have the resources and expertise for evaluating, receiving, processing and liquidating both publicly traded shares and private business interests. And by contributing some of those shares directly, you may not only address some of the tax considerations of an IPO windfall event, but you may achieve maximum philanthropic impact on the charities and causes you support.
Related: 4 Ways Charitable Giving Can Help Reduce Your 2020 Taxes
There are two tax benefits associated with a gift of IPO stock. If you itemize deductions on your return and make a stock donation, you may claim a fair market value charitable deduction for the tax year in which the gift is made. Additionally, you can potentially eliminate the capital gains tax you would have otherwise owed if you sold the stock yourself and donated the cash proceeds. This can mean up to 20% more that is available to support your favorite charities and causes.
This hypothetical case study with Sarah, an early employee at, say, ABC tech startup, illustrates the benefits. Sarah's incentive stock options, which she exercised several years ago, have seen significant appreciation since the company's IPO a few months ago. Now that the lock-up period is expiring, Sarah plans to donate some of her appreciated stock to her favorite charities this year.
This hypothetical example is only for illustrative purposes. The example does not take into account any state or local taxes or the Medicare net investment income surtax. The tax savings shown is the tax deduction, multiplied by the donor's income tax rate (37% in this example), minus the long-term capital gains taxes paid.
Option 1, as outlined above imagines that Sarah sold the stock, paid federal capital gains taxes and donated the net proceeds.
In option 2, Sarah gifts her stock directly to a public operating charity or donor-advised fund. In this scenario, Sarah may be able to eliminate capital gains taxes, and may be eligible for a current year income tax deduction for the full fair market value of her stock, which leaves her with more for charity and larger tax savings.
In addition to the potential tax benefits described above, the following considerations may apply.
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1. Donate long-term held shares with high appreciation.
Incentive stock options for donated IPO shares must have been held more than one year from exercise date and two years from grant date. The shares should also have appreciated in value to realize the maximum tax benefits.
2. Avoid prearranged sales.
Any arrangement that would require a donor-advised fund or other public charity to sell the stock upon receipt should be avoided. This kind of "prearranged sale" may not carry the same tax benefits.
3. Be mindful of lock-up restrictions.
The issuer's counsel determines if and in what manner IPO stock may be donated during a lock-up period. Any restrictions that materially affect the value of the shares or prevent the shares from being freely traded may require a qualified appraisal to substantiate the fair market value, and such restrictions may lead to valuation discounts. Be sure to consult with your corporate counsel and the donor-advised fund or other public charity when donating IPO stock.
Related: These Are the Ten Major IPOs To Watch For in 2021
4. Consider whether Rule 144 legend and affiliate restrictions apply.
If the IPO stock is restricted by legend or owned by an officer, director, or 10% shareholder, then the company's general counsel must give permission to donate the stock. As a general rule, restricted stock must be sold in accordance with Securities Act Rule 144.
Review this infographic to learn more about donating IPO stock and other appreciated non-cash assets to potentially maximize your tax savings and your impact on favorite charities.