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Charitable individuals always have a multitude of choices with respect to how to best benefit charities and charitable purposes, while having Uncle Sam subsidize the gift with tax savings.
2020 is the first year in modern tax history that an individual can get a tax deduction for up to 100% of his or her adjusted gross income by giving cash to a public charity or community foundation.
Most affluent taxpayers who are extremely charitable normally try to give approximately 50% of their adjusted gross income to charity each year, which is the normal limitation, but these individuals get better tax results by giving appreciated stocks, appreciated real estate, or other items that are worth more than their original cost in order to get a double benefit:
- A tax deduction for the value of what is given, and
- Not having to pay capital gains tax on the appreciated asset that is transferred.
Many taxpayers have their own private foundations, which enable them to get a tax deduction and recognition now, while being able to control the foundation and dole out benefits or conduct charitable activities over the years. Many advisors feel that a private foundation is not called for unless there are significant assets contributed, but we have not found this to be the case. Even $10,000 donated to a simple charitable foundation trust can bring a lot of satisfaction and goodness to a family and the charitable causes that the family supports. If things go well the family can donate much more, or attract donations from others.
When contributions are made to a non-operating private foundation the percentage of adjusted gross income that can be deducted will be limited to 20%, if funded with appreciated assets, or 30%, if funded with cash.
Many advisors do not realize that a private foundation can qualify for the same 50% deduction that applies to public charities, if it is “active,” which is typically not difficult to achieve.
When the 100% deduction was first enacted, we had hoped that the language of the statute would allow an individual to donate an amount equal to 50% of adjusted gross income in appreciated assets, and then up to another 50% of adjusted gross income in cash to completely zero out income taxes, but it appears that the correct interpretation of the law is that there has to be 100% cash given to deduct that amount. For example, some advisors think that a taxpayer with $400,000 of adjusted gross income could donate $200,000 in appreciated stocks to a private foundation and then another $200,000 in cash to get a $400,000 deduction, but the IRS will probably limit the deduction to $200,000 and allow the excess to be deducted under the “carry forward” rules, which allow excess deductions to be carried forward for up to 5 years.
The tax savings for those who do donate more than 50% of adjusted gross income may not be nearly as significant as one would think, since the donor’s tax bracket is reduced by the charitable deduction.
For example, a married couple with $1,000,000 of taxable income is in the 37% tax bracket on all income exceeding $622,050.
If they give away $500,000 in appreciated stock, the first $377,949 saves them 37% of that amount, the next $122,051 saves them 35% of that amount, and their total incremental savings is 36.51% ($182,559 total savings).
At $500,000 of taxable income, they are in the 35% bracket, but the total tax savings from taking the taxable income down from $500,000 to zero is $124,590, for an average bracket of 25%.
In fact, if they bring their taxable income down to only $100,000, the income tax would be $13,580, so the last $100,000 that they gift only saves them $13,580.
Notwithstanding this, individuals who are certain that they are going to leave their assets to charity on death, and that they will not need the assets during their lifetime, still do better by annually gifting the amount that maximizes income tax savings, even when those income tax savings are modest.
Charitable taxpayers who have sophisticated advisors are able to use structures that can yield a better tax result than what is discussed above.
For example, an individual who wants to benefit both charity and his or her family while avoiding estate and gift taxes can establish a “Zeroed Out Charitable Lead Annuity Trust,” and put $1,000,000 worth of investments into the trust to receive a $1,000,000 tax deduction, although the trust may pay significant benefits to his or her children after a term of years.
An example of this would be if the taxpayer places $1,000,000 into a Charitable Lead Annuity Trust that pays $110,000 a year to whatever charity or charities are chosen over 12 years, with whatever is left after the 12th year to go to the taxpayer’s children or a trust for their benefit. The taxpayer can get a full $1,000,000 income tax deduction, and whatever is left after the 12th year can go to the children or in trust for them and not be considered to be a taxable gift.
If an individual owns 49% of a family LLC with $3,000,000 of real estate that pays dividends exceeding $225,000 a year this 49% ownership interest may be valued at $1,000,000 because of discounts that can apply. If this LLC interest is contributed to a CLAT and valued at $1,000,000, then significant value may be passed estate and gift tax free to the children after the 12th year.
The next most popular vehicle is the Charitable Remainder Unitrust.
Under this arrangement, a person can donate appreciated assets to a trust and serve as trustee, while receiving a certain percentage of the value of the assets each year for a term of years.
At the end of the term of years, which can be a set number of years or the lifetime of one or more individuals, the remaining assets pass to charity.
The donor to the trust receives an income tax deduction at the time of formation, even when the charity will not receive a distribution, if any, for a number of years.
Oftentimes, an individual who is selling an asset for a large capital gain will transfer some or all of the asset to a Charitable Remainder Unitrust in order to postpone paying the income tax on the gain, which becomes taxable ratably as payments are made from the trust to the individual.
For example, an individual may want to sell stock worth $1,000,000 that only cost $100,000, generating a $900,000 capital gain tax, plus the 3.8% Medicare tax. If she lives in California then the combined Federal and state income taxes will normally be about $300,000 and the Medicare tax will be $34,200 (3.8% of $900,000), which adds up to a total of approximately $342,200.
She could instead donate the stock to a Charitable Remainder Unitrust that pays her 8% of its value per year for 15 years, with the remainder going to charity.
The trust would receive $1,000,000 income tax-free from the sale, and might invest that in municipal bonds and zero dividend growth stocks.
If the trust holds its value, then she will receive $80,000 a year and pay capital gains tax on $80,000 a year, to spread the income out over the lower tax brackets. She might also move out of California to not be subject to its 13.3% income tax on payments received from the trust after she leaves. This is why Austin, Texas is sometimes referred to as the fourth largest city in California.
The 3.8% Medicare tax will not apply if her taxable income does not exceed $200,000 per year.
For example, this might result in paying income tax on the capital gains at an average tax bracket of 15%, over a number of years, as opposed to paying 23.8% (when you include the Medicare tax) Federal tax and State tax in the year of sale.
There are sophisticated kinds of charitable trusts called NIMCRUTs and FLIP-NIMCRUTs that can facilitate allowing the donor to not have to receive payments for a number of years, to facilitate continued tax deferral.
Only a relatively small part of a Charitable Remainder Trust has to be expected to be paid to charity – based upon 10% of the initial value, as calculated on a “future value” basis.
The bottom line is that generous individuals should get with their advisors and determine what is best for them, charities and tax savings, well before December 31st.
Good CPAs and tax lawyers will be very busy from now until the end of the year but will hopefully do their best to help clients understand options and opportunities during a time that charities have more needs than ever.