On Sept. 27, the “Gang of Six” released a summary of their proposed tax reform legislation. The 9-page document focused on a number of areas, including sweeping changes in our nation’s corporate, individual and estate tax structure.
Here’s an overview of the proposed changes to individual income tax rates and what’s deductible before reaching the amount of income subject to those rates, as well as the impact the proposed framework could have on philanthropic planning. While many believe that in the final analysis, the estate tax may be retained in some form and there may be one more higher tax bracket to help pay for the middle class cuts, my analysis assumes that what’s been proposed is actually enacted.
The place to begin from a charitable perspective is the proposed tax rate structure. The proposal reduces the current 7 rate structure of 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent to three rates of 12 percent, 25 percent and 35 percent. While the top tax rate is reduced, the devil, as always, is in the details. The document is silent on where the various rates begin and end so it’s impossible to determine the cumulative impact on a particular individual of “running the brackets.”
It seems clear, however, that the maximum rate on higher income individuals will be reduced. That will mean that all deductions will be worth less and the after-tax cost of mortgage interest and charitable gifts will increase. The formula for determining the after- tax cost of a charitable gift is: gift – (tax rate x gift). In a 39.6 percent maximum tax bracket, the cost of making a charitable gift of cash is $1 – $.396 = $.604. If the maximum tax rate is reduced to 35 percent, the after-tax cost rises to $.65, an increase of 7.6 percent.
The difference is more significant for gifts of qualified appreciated assets. In the case of such gifts, the cost formula includes savings from bypassing capital gains tax on the donated asset as there’s no realization event. The formula for gifts of appreciated assets is: gift – (ordinary tax rate x gift) – (capital gains tax rate x gift – cost basis). The minimum cost for appreciated assets under current law is $1 – $.396 – $.238 = $.366. Under the current proposal, the minimum cost would be $1 – $.35 – $.20 = $.45. The capital gains tax avoided doesn’t include the Medicare tax, which would presumably be repealed under the act. This represents an increase of 23 percent per dollar of appreciation donated. Thus, the effective impact of the proposed rate structure would be to increase the cost of gifts of appreciated property significantly more than gifts of cash.
The changes in rates outlined above are irrelevant if taxpayers are unable to deduct their charitable gifts. In that case, the after-tax cost of a gift of cash is $1 per dollar donated. The minimum after-tax cost of making a gift of appreciated property would increase to $.80 per dollar donated (the capital gains tax would still be saved, as the benefit of the gain is still passed to charity without realizing and paying capital gains tax on a gain). This amounts to a 66 percent increase in the cost of giving cash and a 119 percent increase in the cost per dollar of appreciation.
This increase in cost would be the practical impact of increasing the standard deduction to $12,000 for individuals and $24,000 for married taxpayers. This impact would be experienced by an estimated 83 percent of taxpayers who currently itemize deductions, as the number of itemizers would be reduced from approximately 30 percent to 5 percent.
Personal exemptions would also be eliminated, along with all deductions except for mortgage interest and charitable gifts. The elimination of the deduction for state and local income, property and sales taxes would mean that only those with very large mortgages would still enjoy the full benefits of deducting their charitable gifts.
Under this scheme, donors who rent or live in a debt-free residence would only enjoy tax benefits for charitable gifts of $24,000 or more ($12,000 in the case of an individual). The practical impact would be that the vast majority of charitable individuals would find themselves making charitable gifts from after-tax dollars.
The best way to consider the effect of this change is to consider the impact from a cash-flow perspective. If a donor would like to give $10,000 and it’s fully deductible, it requires $10,000 worth of income to make the gift. If, on the other hand, the gift is no longer deductible, a donor in a 35 percent tax bracket must earn $15,384 and pay tax of $5,384 to make the same gift. This amounts to a 53.8 percent increase in the pre-tax earnings required to make the gift. It’s this prospect that’s led economists to estimate a reduction in giving of $13 billion or more should the current or similar past proposals become law.
Estate and Gift Tax Proposals
The Republican majority in Congress has long promised to eliminate the federal estate tax or “death tax” as it’s become known in the vernacular. The most recent proposal delivers on that promise. From a practical perspective, the current exemption amount of $10.98 million results in the effective elimination of federal estate tax for 99.4 percent of Americans (according to 2015 estate tax data and estimated deaths for 2015). The proposed repeal would eliminate the tax on the remainder of the top 1 percent for whom the tax currently applies.
The proposed plan is silent on the fate of the gift tax, though it’s been reported that in all likelihood, the gift tax would be retained to discourage income splitting strategies.
Some have predicted that there would also be a carryover basis for inherited property. While no tax would be owed on assets transferred at death to loved ones, the heirs would be required to pay capital gains tax on the subsequent sale of the assets and wouldn’t be allowed a fair market deduction for donation of these assets to what an earlier Trump proposal referred to as “private charities.” Presumably, such assets would still be deductible at full value to public charities.
While some have predicted that an elimination of the estate tax would result in decreased charitable giving through estates, surveys of high-net-worth (HNW) individuals don’t bear out this conclusion.
The results of a survey of HNW individuals released last year reveal that the vast majority of wealthy individuals wouldn’t reduce and would in many cases actually increase the amounts bequeathed to charity through their estates.1 This is because many wealthy individuals first decide the maximum amount they wish their heirs to receive, pay the tax on that amount and direct the balance of their assets to charity. If there’s no longer tax due on the amount left to heirs, the disposable assets in the estate increase and, hence, so does the remainder received by charitable recipients.
It should also be noted that an actual bill introduced in Congress (H.R. 3988) in early October would provide relief for the majority of donors who would no longer itemize charitable gifts by providing for an “above the line” non-itemizer deduction with a cap of one-third of the standard deduction. Under this provision, a single taxpayer could deduct up to $4,000 worth of charitable gifts and a married couple up to $8,000.
Those making larger gifts would still be allowed to deduct them “below the line” to the extent, when combined with mortgage interest, their total deductions exceed the proposed standard deduction amounts of $12,000 or $24,000.
Other proposals that haven’t yet been reduced to an actual bill or official proposal would include various other ways to structure above the line adjustments to adjusted gross income that would result in restoring the benefits of charitable deductions in a revenue neutral way to those who would otherwise experience the increased costs outlined above.
While there are many details that still remain to be fleshed out, argued and negotiated, we’ve now been given a first glimpse of where individual tax reform may be headed from a charitable gift planning perspective.