The market is up, and the continuing economic recovery may have you thinking about sharing the wealth.
Creating a philanthropic plan for your family can be daunting, given all of the available structures and the complex tax and administrative rules governing charitable donations.
The first step in a charitable giving plan is to define your objectives. Among the questions you should ask include:
- Are you giving for purely selfless goals of supporting a particular charity, cause or endeavor?
- Are you motivated primarily by tax-planning considerations, to reduce the tax bill resulting from an abnormally high-income year?
- Are you trying to establish a philanthropic legacy to survive for generations after your death?
- Do you want to involve your children as a way to pass family values to younger generations?
- Do you already know which charities you want to support?
The answers will help determine which charitable vehicles are best suited to accomplish your goals.
The government has provided a nice incentive to charitably inclined individuals in the form of the charitable deduction. Generally, individuals can deduct cash gifts in an amount up to 50 percent of their adjusted gross incomes (AGI) for the tax year, and up to 30 percent of AGI for gifts of appreciated property, to public charities as defined in Internal Revenue Code section 501(c)(3). Gifts to private foundations are deductible at 30 percent of AGI for cash gifts and 20 percent for appreciated securities. Amounts exceeding these limits carry forward to future tax years for up to five years.
The primary consideration for the income tax ramifications of your charitable giving is timing. Look at how your income in the current year compares with past earnings, and get an idea of how that pattern will play out going forward to project future income. The objective is to get the maximum tax benefit for your contribution dollars. Strive to match high income with large deductions in one year. For example, consider a retiring executive who will receive a large payout upon leaving the company, and thus have an abnormally large AGI in that year. This high income level may push this person into the highest tax bracket for that year. In such a case, deductions should be accelerated into that tax year to achieve the most benefit.
If the situation describes one that you are encountering, or expect may happen in the future, here is some advice that is not usually heard among sophisticated planners. If you have a high-income year, you know what charities you want to support, and the percentage-of-AGI limit is not likely to come into play, then just give away the assets. Many planners, marketers, investment companies and lawyers will tout the benefits of numerous complex charitable giving structures (which do have their place, to be discussed further in this article), but in the case described above, they can be unnecessary — not to mention needlessly burdensome and expensive to maintain and administer. Just give it away.
One of the best ways to capitalize on this strategy is by donating appreciated shares of stock, mutual funds or other publicly traded securities in-kind directly to the charitable organization. This is a powerful strategy because it accomplishes both income-tax-planning and charitable objectives. Consider the following example: You own shares of a stock you bought years ago for $2,000 that is now worth $10,000. You have an $8,000 unrealized gain that you would pay capital gains tax on if you sold the shares and gave the cash to charity. Instead, you can give the shares directly, pay no tax on the transfer and still get a $10,000 tax deduction that year. You also avoid paying tax on that built-in gain forever.
However, what if you know you have this one-time opportunity to capitalize on deducting charitable contributions in a high-income year, but have no idea where you wish to give? This is when some of the more complex solutions available may be of great benefit. One such structure is the “donor-advised fund,” a charitable-giving vehicle wherein an individual makes an irrevocable, immediately tax-deductible contribution, and at any time thereafter can recommend distributions to qualified charitable organizations.
It is important to note that recommendations to the sponsor of a donor-advised fund are nonbinding. Many companies run simple and easy-to-use donor-advised funds at low cost, such as Fidelity Charitable Gift Fund. The administrative burden is low because the sponsoring institution handles the complex rules of running such a fund, including tax returns. For a donor where absolute control is not necessary, but an immediate tax deduction is desired, these vehicles can make sense. Donor-advised funds also are appropriate when the donor desires anonymity, an option this structure provides that other methods do not.
A donor-advised fund would not meet the objectives of a family that is trying to establish a foundation, where members of the family can be elected to board seats and thus control the disposition of the assets for generations. Private foundations sponsor or aid charitable, educational, religious or other activities serving the public good, primarily by making grants to other nonprofit organizations. A foundation is a nongovernmental, tax-exempt 501(c)(3) entity, with articles of incorporation and a board of directors.
A benefit of a foundation is the immediate deductibility of gifts to it, although as described above, the percentage limitations for tax purposes are lower. Other non-tax benefits, in addition to control, include public recognition of the family. This can create visibility and influence for family members, and can be a perpetual community presence and a reminder of the family’s generosity. Foundations can also protect assets from personal bankruptcy. This also would be a benefit of giving the assets away immediately and of donor-advised funds.
Private foundations can have significant drawbacks that make them practical only for high-net-worth families that want to devote substantial assets to philanthropy. Foundations can be expensive to run and administer, with required start-up legal fees, ongoing meeting expenses, administration fees and investment management fees. Also, private foundations face complex rules against self-dealing, limitations on investments and other complications that are beyond the scope of this article. Professional help is usually required to establish and run a private foundation.
A further drawback of foundations, in addition to the lower limits described above, is that gifts of certain appreciated property are limited to the cost basis of the asset. This rule would often defeat the purpose of giving away certain appreciated assets, such as a closely held business, to charity.
There are yet other charitable structures that can satisfy various objectives. In a situation where the donor wants to continue to benefit from the assets to provide for living expenses, a charitable remainder trust (CRT) may be an attractive option. In a CRT, the donor receives a stream of income for a term of years, or the remainder of his life, from a trust established as a split-interest trust. After the term expires, or he dies, the assets remaining in the trust pass to one or more charities, which can be selected when the trust is created or later.
In a CRT, an income tax charitable deduction is allowed when the trust is funded. The deduction is equal to the present value of the remainder interest that will pass to charity. The income interest in the trust can be structured as an annuity (a CRAT, where the “A” stands for annuity), or as a percentage of the assets in the trust at December 31 of the prior year (a CRUT, where the “U” stands for unitrust).
A typical CRUT may work as follows: The donor funds a trust with $1 million, and will receive an 8 percent payout annually of the prior year’s December 31 ending value. In this scenario, the donor would receive $80,000 in Year 1. The trust can be invested for a high rate of return in a diversified equity portfolio, assumed to return 10 percent a year. Further assume the payout is at the end of the year. That means the trust grows to $1.1 million throughout the year, and, after the payout, is worth $1.02 million. Next year, the unitrust payout would be 8 percent of this higher number. In years where the market declines, the payout would be lower. On death, any assets in the trust pass to charity.
A donor who has enough money to comfortably provide for her lifestyle may be interested in the reverse structure, the charitable lead trust (CLT), which works exactly opposite the CRT. In this structure, an annuity or unitrust stream is paid to the charity over a term of years or lifetime. Any assets remaining in the trust can revert to the donor or pass to her heirs. Both the CRT and CLT vehicles are governed by many complex rules and regulations, and are not without cost to set up and run. They should not be pursued without skilled counsel.
In addition to assessing the various options for philanthropic planning, properly evaluating where your charitable donations are going is an equally, if not more important, consideration. You can use resources such as www.charitynavigator.org and www.guidestar.org to determine the percentage of donations that goes toward administrative expenses, obtain ratings of charities, and assess how much impact a dollar of donations has on the underlying cause.
With thoughtful consideration of both where you want your charitable donations to go and of the structure that best achieves your goals, you can maximize the impact of your dollars on charity and your own wealth. With more wealth, you will have more to give away next year.