When asset values are down, many advisors are reluctant to bring up charitable giving with their clients. They shouldn’t be. We had an extremely long bull market until recently. Many of your clients still have huge profits in the form of appreciated assets that will eventually be taxed if the right planning isn’t done.
Charitable Giving vs. Loss Harvesting
Advisors often ask me this time of year – especially during down markets -- if they should be telling clients to do charitable giving or loss harvesting. This is generally how I frame it:
When charitable giving makes sense. By donating an appreciated stock directly to an Internal Revenue Code Section 501(c)(3) charitable organization, including a donor-advised fund (DAF), your client gets a tax break based on the fair market value (FMV) if they itemize deductions, and they avoid paying taxes on the capital gains. The charity or DAF also avoids paying capital gains tax and can sell the stock to further its mission with the cash proceeds.
Additionally, giving vehicles like a pooled income fund (PIF) or a charitable remainder trust (CRT), reduce the donor’s charitable tax deduction and allows the donor to retain an income stream, usually for the rest of their life. In difficult times, hanging on to income provides financial security and peace of mind.
The deduction of FMV for a direct gift to charity still has limitations. For appreciated securities, the deductible amount is 100% of FMV, capped at 30% of adjusted gross income (AGI). Many donors who consider this type of gifting are older and no longer in their prime earning years. Therefore, their income may be lower than in the past, and the charitable income tax deduction may not be as valuable as it once was. For example, current tax tables say a PIF deduction for a husband and wife who are both age 65 would be a little over 70% for a gift made in 2022. In exchange for a lesser deduction, the couple would retain rights to the entire income from their gift as long as they remain alive.
When loss-harvesting makes sense. However, if your client intends to donate a stock that’s trading at a loss, your client is better off selling the stock and then donating the cash proceeds. That’s because the tax deduction is limited to the lower of your client’s cost basis or the FMV. The big advantage here is that the loss can be used to offset other capital gains or other taxable income (up to $3,000), and the deduction for gifts of cash can be used up to 60% of AGI.
If you have cause-oriented clients who are planning to sell their companies – or otherwise coming into a windfall -- they may be asking you about an IRC Section 501(c)(4) nonprofit due to highly publicized recent uses of this vehicle such as 83-year-old Patagonia CEO, Yvon Chouinard and 90-year-old conservative electronics mogul, Barre Seid (Tripp Lite).
As many of you know, the more common Section 501(c)(3) non-profit organization is typically created for religious, charitable, educational, scientific and/or educational intent. They’re tax-exempt entities that conduct research and are limited to the amount of lobbying, advocacy or political activity they can do. Donations to Section 501(c)(3) organizations are tax-deductible.
By contrast, a Section 501(c)(4) is considered a “social welfare group” that can advocate for causes and propositions, just like Section 501(c)(3)s can. However, Section 501(c)(4)s can also endorse specific candidates, something Section 501(c)(3)s can’t. Examples of Section 501(c)(4)s include political action groups and lobbying initiatives. While non-profit organizations with this status are also tax-exempt, donations to 501(c)(4) groups aren’t tax-deductible.
Patagonia CEO, Yvon Chouinard and his family used the Section 501(c)(4) when they recently transferred ownership of their $3 billion outdoor apparel company to a specially designed trust and a non-profit organization called “Patagonia Purpose Trust.” Chouinard’s children didn’t want to take over the business, and Chouinard didn’t need the money. But mainly, they also wanted to make sure the company would continue to support environmental causes near and dear to the Chouinards. Seid was equally motivated, except his passion was supporting conservative political groups instead of environmental causes. Seid wanted to ensure those groups remained well-funded in a tax-efficient way -- something he couldn’t accomplish via a Section 501(c)(3). While there are some tax benefits to the Section 501(c)(4), the main reason they are used by the wealthy is for greater flexibility in funding political causes and groups.
Higher Rates Benefit Many Donors
One positive outcome of the Fed’s rate hiking cycle is that higher interest rates put more money in the pockets of older Americans who tend to have more savings than debt than younger Americans. We haven’t seen this situation in many years, but it means older donors will likely have more money to give away in 2022 compared to their younger peers. Low interest rates had a negative effect on annuities and trusts, which are key to many planned giving strategies. Higher rates will likely spur more interest in these traditionally important planned giving tools.
With the government strapped for cash to support pandemic-era relief programs and the Inflation Reduction Act, the capital gains rate could go higher in the near future, especially for taxpayers earning over $1 million. That’s good for charitable giving as it creates a powerful incentive for impacted taxpayers to support charitable organizations by donating appreciated assets like stock and real estate. Another Biden proposal would have a substantial impact on the way capital gains are taxed on transfers of wealth to heirs, on top of the estate and gift tax exemption being cut in half in 2026. These changes also have major ramifications for estate planning, including existing estate plans. Charities and financial advisors would be wise to keep an eye on these and other tax law changes that may be coming in the relatively near future.
Get the Ball Rolling
Regardless of which giving solutions you recommend to clients, just remember it takes time to get planned giving right. Don’t wait until the last minute. Unlike tax returns, there are no extensions allowed for gift plans. Now’s the time to get the ball rolling. As an advisor, you can make a tremendous difference in clients’ lives by educating them about the tax and estate planning advantages of smart philanthropy and by preparing the next generation(s) of their family to be responsible stewards of the family’s wealth and legacy.