It now appears likely that Congress will take up a major tax reform initiative in coming months. While it’s still uncertain whether a bill will actually be passed and signed into law this year or next, the administration and many in Congress seem determined to address this legislation sooner than later.
Many believe that early proposals that have been put forward by the House Ways and Means Committee will form the blueprint for the ultimate legislation and, as such, offer direction to planners regarding areas on which they might want to act prior to possible changes.
Consequently, advisors to charitably inclined clients may wish to consider recommending that they act now on certain types of gifts, prior to passage of legislation that may make changes effective from the date of introduction of a particular bill. It’s also possible that the changes may be so extensive as to permanently reduce the tax savings associated with charitable giving for some individuals.
History teaches us how responsive clients can be to advice to make charitable gifts in advance of legislation that may reduce benefits. For example, during the period leading up to the passage of the Tax Reform Act of 1986 in October 1986, donors responded in a way that resulted in the largest percentage increase in charitable giving by individuals since these figures began to be tracked in 1955. (See “Increase in Charitable Giving,” p. 9.)
Note that giving actually declined the following year, further indicating that donors had accelerated billions of dollars of gifts to take advantage of greater tax savings in advance of changes under the 1986 Act.
A Bird in the Hand
A confluence of factors not seen since the mid-1980s may make now the best time in decades to complete larger charitable gifts. The combination of record high investment market levels, rising real estate values in many markets, relatively high tax rates that may soon be reduced and higher adjusted gross income levels that serve to increase amounts that can be deducted this year are among the “birds” that are now “in the hand” and could very well lead to record levels of individual giving in coming months.
On top of macro environmental factors, large numbers of charities are now launching capital and endowment campaigns that had been delayed for years pending recovery from the negative impact of the Great Recession. This all adds up to 2017 being perhaps the year with the highest amount of charitable giving by Americans.
Let’s look at a number of the factors in play in more detail and suggest a number of possible strategies that may help clients maximize their philanthropy while we await changes that may be in the offing.
What, When and How
In my March 2017 column,1 I wrote about the paramount importance of the “who” and “why” of charitable gifts. That is, of course, where all gifts begin—and it can be unwise to over-emphasize tax and other financial considerations of charitable gifts too early in the process. But, after determining the scope of a client’s charitable interests, it can be vitally important to explore the factors that can rightfully influence the “what,” “when” and “how” of charitable gifts—especially in the case of larger ones.
One of the most powerful tax planning tools in the philanthropic arena is the ability to give certain properties that have increased in value and would give rise to significant long-term capital gains (LTCGs) liability if they were to be sold.
In the case of qualified long-term appreciated property, outright gifts can be used to offset other taxable income, while bypassing the tax that would be due on a sale—a result of the fact that a gift isn’t a sale or other realization event that would result in a tax. For an individual in the highest federal tax brackets, the cost of giving appreciated assets can be as little as $.37 per dollar of appreciated property given, as opposed to $.60 per dollar of cash donated.
Given the fact that tax reform measures are expected to reduce marginal ordinary and/or capital gains tax rates for many taxpayers, it could be wise for some clients to accelerate gifts of cash and appreciated assets into 2017 when the after-tax cost of making charitable gifts could be lower.
This special advantage to giving LTCG property has often come under attack in various tax reform discussions dating back to the original Reagan administration proposals in the early 1980s. While current proposals don’t reduce deductions to cost basis for all gifts of appreciated property, the Camp proposal from 2014 (that will reportedly serve as the basis of the Ways and Means Committee reform proposal) would limit appreciated property gifts to adjusted basis with exceptions for publicly traded securities and gifts of tangible personal property for related use.
With the Dow hovering around 20,000 as we go to press, a good strategy may be to realize gains and diversify while balancing those gains with gifts of other investments that are most highly appreciated.
In other cases, a client who owns stock that’s increased greatly in value and believes it may continue to grow in value may wish to make a gift of all or part of that security and use cash generated from sales or other sources of income to repurchase the security at its current market price. When the dust settles, the client has made a significant gift and owns new shares of the same issuer, but with a new basis equal to current market value. If the security then increases in value, there will be less gain on a subsequent sale. If it declines, there will be a loss on account of the new higher basis in the security, rather than just less gain to report.
When appreciated real estate is concerned, the possibility of limitation of deductions to cost basis may make this an especially opportune time to consider gifts of such property.
Augmenting Retirement Plans
Other clients, among them aging Baby Boomers who may now be attempting to “catch up” on their retirement savings, are looking for ways to tax-efficiently diversify their investment portfolios, provide for future retirement income on a tax-favored basis and leave a charitable legacy at the end of their lifetime. They may find now to be a good time to consider funding a charitable remainder unitrust (CRUT) or other gift that provides income for life or other period of time.
For example, Jim and Mary, both age 70, invested $150,000 in a low yielding growth stock in 2009. Today, the stock is worth $1 million and pays a dividend of 1 percent, or $10,000. They would like to sell and enjoy additional income in retirement.
If they sell, they’ll realize a capital gain of $850,000 that could give rise to capital gains and Medicare contribution tax of over $200,000 at the federal level (and possibly more in state taxes), leaving $800,000 to reinvest. At a 5 percent return, they would generate income of $40,000. Alternatively, if they fund a $1 million 5 percent CRUT, the trust can sell the security and diversify the investment free of capital gains tax at the time of the gift. They’ll receive $50,000 in income the first year, much of which will be taxed at lower capital gains tax rates under the tier structure of income reporting for a CRUT.
In addition to not owing $200,000 in capital gains tax at the time of the gift, they’re entitled to a charitable income tax deduction of $412,000, which represents the value of the charitable gift of the remainder of the trust at their death. They could use this deduction to offset tax on that amount of income beginning in the year of the gift and up to five future years under current carryforward provisions.
Jim and Mary decide to complete their gift now for a number of reasons. First and foremost, they’re chairing a local fundraising campaign and would like to make a leadership commitment. From a tax and financial planning perspective, they’re concerned that the value of the security used to make their gift may not hold its value given future uncertainties, and proposed caps on charitable and other deductions may make it impossible to fully use the charitable deduction associated with their gift.
In addition, their financial advisor suggested they “carve out” an income interest for the charitable remainder recipient beginning immediately. They decide to provide that 20 percent of their unitrust payment each year go directly to the charity. In so doing, they ensure a “quasi-endowment” gift that would require $200,000 worth of true endowment funds to provide at a 5 percent spend rate for a charity, and they ensure that they won’t pay tax on those funds should charitable deductions be limited under tax reform measures. They realize that providing for the carved out income to the charity is the same as receiving it and fully deducting it.
Under campaign guidelines that credit gifts of their nature at face value for people age 70 and older, they’re pleased to learn they’ll be credited with a $1 million gift to the campaign.
The 10 and 10 Plan
Suppose Ben and Jackie are both age 50 and would like to make a gift similar to that made by Jim and Mary. At their relatively young ages, however, campaign credit for their deferred gift wouldn’t typically be allowed or would be deeply discounted due to their long life expectancy.
Gradually rising interest rates reflected in higher applicable federal midterm rates (AFMRs) makes possible another option they may wish to consider. Suppose they owned the same stock as Jim and Mary. They would like to generate more cash flow over the next 10 years while their teenage children complete their educations and are willing to terminate a trust and complete a gift at the end of the 10-year period. They decide to structure a 10 percent charitable remainder annuity trust (CRAT) that will make payments for 10 years.
Over the 10-year period, they’ll receive payments totaling $1 million. The $100,000 payments will be taxed largely at capital gains rates under the tier structure of income reporting for CRATs, so they anticipate netting approximately $78,000 per year, resulting in some $780,000 in cash flow over the 10-year term of the trust. If the trust earns an average total return of 6.25 percent, there will be $500,000 remaining for charity when the trust terminates.
They won’t owe as much as $200,000 in capital gains tax in the year of their gift and are entitled to a deduction of $120,000 for the year of their gift. This gift wouldn’t have been possible as recently as December 2016, when the AFMR of 1.8 percent would have resulted in a projected charitable remainder value of less than the 10 percent required to qualify the trust.
They’re pleased to be credited with a gift of $500,000 under campaign guidelines. The charity prefers this gift that can be expected to yield $500,000 in just 10 years, rather than a gift that wouldn’t be realized until the death of the survivor in an estimated 39 years.
Low Interest Rate Opportunities
The current low interest rate environment also makes certain other gifts very attractive. For example, clients may own a second home they would like to continue to enjoy for a number of years before using it to fund a large charitable gift. Low AFMRs make it possible to make a gift of the home today, enjoy its use for the time desired and be entitled to an immediate income tax deduction equal to a large portion of the value of the home.
For example, Margaret and George, both age 75, have owned a lake house for over 30 years. They use it less and less, and they have no children or others they wish to leave it to. They would, however, like to use the home for another five years. They’ve been asked to fund a scholarship at their joint alma mater. The home is appraised at $750,000. How can they accomplish their objectives while maximizing tax benefits under current law?
They were surprised to learn that they could donate the home today and retain the right to use the property for five years. They would remain responsible for taxes and other costs of ownership during that period. At the end of five years, their right to use the home would terminate, and the property will immediately be owned outright by the charity. Because of the AFMR of 2.4 percent they’re allowed to use at the time of their gift, they’re entitled to a charitable income tax deduction of some $629,000, representing 84 percent of the home’s value.
They’re advised to act as soon as possible, as the possibility of higher interest rates reducing their deduction, the chance that the property value could fall, the proposed limitation to cost basis for gifts of real estate and the impact of possible caps on charitable deductions in the future could have an effect on their ability to fully use the current tax benefits that greatly reduce the cost of making a gift in this way.
Other planning tools, such as charitable lead annuity trusts (CLATs) are also more favorable in times of lower interest rates. While there are proposals to eliminate federal estate taxes, many believe the gift tax may remain. A CLAT funded during lifetime is a way to transfer assets free of gift tax while also making significant gifts to charity over time. Also keep in mind that, just as in the case of the CRUT income carve out described above, gifts made to charity from a CLAT flow outside the donor’s taxable income and would represent a way to bypass tax on income that may otherwise be received by the donor and donated without the benefit of a charitable deduction.
These are just a few ways well-advised clients may wish to consider making gifts in contemplation of tax reform proposals. While Congress has publicly committed to preserve benefits of charitable giving as part of any tax reform, the devil is in the details and, as always, there will be changes that may negatively impact current tax planning techniques while offering new ones that may not benefit the same donors making gifts of the same types of property today.
1. Robert F. Sharpe, Jr., “Taxing Matters,” Trusts & Estates (March 2017), at p. 7.