Charitable Giving if the Tax Laws Change

Take-Away: If many of President-elect Biden’s proposed tax law changes are implemented in the next few years, they will have a dramatic impact on how individuals engage in philanthropy. Some of the proposed changes will create more challenges to implement philanthropy, while other existing opportunities will still be available and might even be enhanced.

Background: Yesterday’s summary provided an overview of many of President-elect Biden’s proposed tax law changes. As we look forward to this year and the years that follow, donors will have to take that changing tax landscape into account as they make their charitable gifts. Some of those considerations follow.

Impact on Charitable Giving: Assuming that Congress goes along with all of Mr. Biden’s tax proposals (which is a big assumption with the Senate’s 60-vote filibuster still in effect) those changes will require a new approach to philanthropy.

• Capital Gains: Despite the COVID-19 pandemic, the stock market rallied after its 30% drop in March, 2020. Now would be an excellent time to use appreciated securities to make charitable gifts, or to fulfill outstanding charitable pledges. Those gifts will usually give rise to a charitable tax deduction equal to the fair market value of the donated assets, which will reduce the donor’s income tax liability without having to pay any capital gain tax on any of the underlying gain.  A donor can use the cash that he/she would otherwise have given to the charity to repurchase the same securities given, or other securities, arguably with the same value, but with a new, higher, income tax basis in the new securities that the donor holds.

Action: Why gift appreciated marketable securities at this time? If President Biden’s proposals become the law: (i) Holding the appreciated securities until the donor’s death will not receive a step-up in the income tax basis of those securities to their date-of-death values; and (ii) If the donor is a high earner with more than $400,000 reported income, some of the underlying capital gain could be taxed as ordinary income tax rates when the securities are sold. A gift-buy-back strategy to increase the income tax basis in the securities will mitigate the exposure to having the gain later taxed at ordinary income tax rates.

• Donor Advised Funds: Many in Congress believe that gifts to a donor advised funds (DAF) are abusive, if the donor receives an immediate income tax charitable deduction, yet the gifted assets are not distributed to benefit charities from the DAF until several years in the future. There are preliminary discussions about imposing restrictions on DAF’s, and private foundations, to require distributions from a DAF (or private foundation) over a condensed time period. This would benefit charities, but it might also lead to less funds being directed to a DAF or private foundation in the years to come if the donor loses control over the timing of the distribution.

Action: Fund a DAF (or private foundation) now with highly appreciated assets, in order to claim the large charitable income tax deduction. One of the proposals under discussion to address the perceived tax abuse is to limit the amount of the claimed charitable deduction, or cause a retroactive denial of the charitable deduction of a gift to a DAF or private foundation if the donated assets are held in the DAF or private foundation for a specified period of time. Current gifts to a DAF might be ‘grandfathered’ from complying with the discussed restrictions.

• Charitable Income Tax Deduction Limited: One proposal by Mr. Biden would be to limit the use of the charitable income tax deduction to a donor’s 28% income tax bracket. Any charitable gifts would not be deductible from income that was subject to the higher income tax rates.

Action: A high earning individual (whose income is above the 28% marginal income tax bracket) who is contemplating a large charitable gift to reduce their taxable income, e.g. anyone contemplating a large liquidity event in a single tax year, should consider making a large charitable gift now to shelter from tax their income that would otherwise be taxed at the marginal 37% income tax bracket.

Opportunities: Some existing charitable giving opportunities still exist and may even prove to be more beneficial if some of the proposed tax law changes come into effect.

• Extend CARES Act Giving: There is some discussion, in order to help non-profits that are struggling due to the pandemic, to expand the CARES Act’s above-the-line charitable income tax deduction of $300 beyond 2020 and possibly to increase that amount, in effect allowing the donor to use pre-tax dollars to implement an individual’s philanthropy.
• SALT Deduction Limitation Repealed: Biden has suggested that Congress should eliminate the 2017 Tax Act’s $10,000 limitation on deductible state and local taxes (SALT). That change would encourage a large group of donors who live in high tax states to again begin to itemize all of their charitable income tax deductions to increase philanthropy.
• Qualified Charitable Distributions Not Included in Income: As most individuals save for their retirement using IRAs, the ability to make a qualified charitable distribution (QCD) from their traditional IRA or their inherited IRA without having the distribution included in their taxable income still makes tremendous sense for older donors. The benefit of a QCD will even be greater if there are higher income tax rates in the future, or compressed income tax brackets that the donor hopes to avoid to keep his or her taxable income in a lower income tax bracket. Also, if capital gains will be taxed at ordinary income rates if the donor reports income in excess of $400,000, since a QCD is not included in the donor’s adjusted gross income for the year, the donor’s QCD’s may help to avoid reportable income in excess of $400,000 and exposing capital gains to ordinary income tax rates.
• Lower Interest Rates: The Federal Reserve has committed to keep interest rates low for the next couple of years in order to restore the economy. Those lower interest rates also interact with prospects for other major tax law changes with Mr. Biden’s election to encourage philanthropy in specific forms.

Split-Interest Trusts: From a charitable planning perspective, the combination of large amounts of cash and low yielding appreciated assets should lead to an increased use of split-interest charitable gifts, like charitable gift annuities (CGAs) and charitable remainder trusts (CRTs.) They combine a present charitable income tax deduction for the gift portion of the transfer that could result in the donor’s lower income tax liability which would be important if income tax rates increase or the income tax brackets are narrowed in the future. In addition, the split-interest gift would bypass the capital gain that would otherwise be recognized on the appreciated asset’s sale, that might otherwise be subject to ordinary income tax rates. Finally, if the split-interest gift was in the form of an annuity, e.g. a CGA or CRAT, the split-interest gift would provide a stable and fixed source of income to the donor in a period of low interest rates.

Charitable Lead Annuity Trusts (CLATs): Low interest rates also make a CLAT a more effective wealth shifting tool, which may be even more important if the federal estate tax exemption drops to $3.5 million and the federal gift tax exemption drops to $1.0 million. A low interest rate makes it possible to pass greater amounts of property to heirs due to lower trust annuity payout rates to the charity and reduce the time the payments ‘lead out’ to charity must last to result in the elimination of the gift or estate tax. With low interest rates, it takes a shorter period of time to ‘zero out’ the gift tax through the use of a CLAT. The result is that the remainder beneficiaries of the CLAT will more likely receive assets at the end of the CLAT’s annuity payment period, and over a quicker period of time. In short, a CLAT can remove assets from the donor’s taxable estate and avoid a possibly higher federal estate tax rate of 45% (or 55%) by transferring those remainder assets to the donor’s heirs with little, or no, transfer tax burden.

Conclusion: New tax laws will offer both pitfalls and opportunities for those who consider how all the factors in-play can be combined in ways that result in individuals making their charitable gifts most effectively. Many existing philanthropy strategies like CRTs, CLATs and QCDs will possibly provide even more tax efficient benefits to both the donor and the charity. Other strategies, like DAFs, may not be as effective as in the past. The federal estate tax charitable deduction may regain some of its past importance if an individual’s estate tax exemption drops to $3.5 million and the federal estate tax rate increases to 45%. Changes in the tax laws will require individuals to carefully consider the timing of their gifts to charity, the property used to fund the charitable gift, and the manner in how the transfer to the charity occurs. That’s plenty for everyone to think about.