estate planning

Tax Efficient Charitable Giving

by Joe Ben Combs, CPA

Tax Manager at Atchley & Associates, LLP

As we all know there are tax benefits associated with donating to charities, religious organizations, universities, etc. We have written in the past about the basics of charitable contributions but we thought it would be good to take it to the next level and share some of the more sophisticated ways we help our clients maximize the tax benefits of their charitable giving. We’ll start with the simplest ideas first.

  1. “Bunching” contributions. You may be familiar with the concept as it is often applied to property taxes. The idea is that if you accelerate next year’s giving into this year (bunching multiple years’ deductions into one year) you can get both deductions this year and then next year you can take the standard deduction that have otherwise been wasted. It’s something I personally have taken advantage of on multiple occasions but it certainly doesn’t make sense for everyone. There are a host of factors that may limit the benefits so it’s definitely worth a quick conversation with your CPA or financial advisor before pulling the trigger.
  2. Qualified charitable distributions. A QCD is a distribution directly from your IRA to a qualified charity. You will not get a deduction for the contribution but the distribution is also not included in your income, which usually yields a better result than if you were to take a taxable distribution and then deduct the charitable contribution. What’s even better is these distributions can be used to satisfy your annual required minimum distributions (RMDs). It is a highly tax efficient way to give to charity. However, there are two major limitations. First, you must be at least age 70 1/2 to make a QCD. Second, the maximum amount you can distribute as a QCD is $100,000 per year.
  3. Donation of appreciated stock. This is one of the most powerful and underutilized charitable giving strategies available. Let’s look at an example to illustrate. Assume you intend to donate $100,000 to a charity. You currently hold a stock that you purchased for $60,000 and now happens to be worth $100,000. You could sell the stock and donate the $100,000 to charity, creating a taxable gain of $40,000 (and a tax hit of $6,000 of tax, assuming a 15% capital gains tax rate). Or you could donate the stock directly to the charity. If you do this, the tax rules allow you to take the same $100,000 deduction as if you had donated cash but avoid recognizing the capital gain. One thing to keep in mind – this strategy cannot be used to avoid short term capital gains as the contributed property must be held for more than a year.
  4. Donor advised funds. A donor advised fund (DAF) essentially functions as a charitable giving account. You are allowed a tax deduction when you contribute to the fund. Once the funds are in the account they are legally no longer in your control but you are allowed to give instructions (technically grant recommendations) to the organization managing the account about how to distribute the funds. They will often even allow you to select how the funds are invested while they are in the account so they continue to grow. This is a great way to manage your charitable giving and can help to facilitate some of the strategies already mentioned. For example, if you want to bunch your contributions this year but you don’t know which charity you want to give to or you just don’t want to give it all right now, you can contribute to your DAF and decide later where and when to distribute the funds. Or let’s say you want to donate a piece of appreciated stock but the organization you want to donate to does not have the structure in place to receive stock donations. You can contribute the stock to your DAF, the DAF will sell the stock, and you can direct the cash proceeds be donated to the charity. DAFs are also a useful tool for those who want to contribute anonymously.
  5. Charitable trusts. There are a variety of trust arrangements that can be used – usually as estate planning tools – to accomplish your charitable goals. We won’t go into all the particulars here but these usually involve a noncharitable beneficiary receiving income for a certain period of time (generally his or her lifetime) and a charitable beneficiary receiving the remainder, or vice versa. Charitable trusts are a good option for those with substantial wealth looking to retain income for their lifetime, maintain control over charitable assets, or create a more flexible plan of disposition for their assets that includes charitable and noncharitable goals. Needless to say, consultation with your CPA and/or attorney is highly recommended before pursuing this option.
  6. Private foundation. For those with substantial wealth who are interested in creating an ongoing charitable operation, a private foundation may be the solution. While these can be expensive to create and maintain, they provide opportunities that none of the previous strategies do. For example, if you are interested in providing free tutoring to underprivileged children in an area that is not served by any other organization, you can create a foundation that does just that. You can claim a tax deduction for contributions to the foundation, maintain control of the operational aspects, and involve friends or family members in the leadership of the organization if desired. Of course there are numerous tax, legal, and administrative considerations to be discussed with your CPA and attorney before going down this road.

Estate planning: Consider a private annuity

Affluent individuals looking for a way to reduce gift and estate tax exposure should take a look at private annuities. These estate planning tools can serve two purposes: You can get a steady income stream until your death, and your children may benefit from a less severe tax bite.

How does it work?

In a typical private annuity transaction, you transfer property to your children (or others) in exchange for their unsecured promise to make annual payments to you for the rest of your life. It’s “private” because the annuity is provided by a private party rather than an insurance company or other commercial entity. The amount of the annuity payments is based on the property’s value and an IRS-prescribed interest rate.

A properly structured annuity is treated as a sale rather than a gift. So long as the present value of the annuity payments (based on your life expectancy) is roughly equal to the property’s fair market value, there’s no gift tax on the transaction. And the property’s value, as well as any future appreciation in that value, is removed from your taxable estate. In addition, a private annuity provides you with a fixed income stream for life and enables you to convert unmarketable, non-income-producing property into a source of income.

Until relatively recently, private annuities also provided a vehicle for disposing of appreciated assets and deferring the capital gain over the life of the annuity. Proposed regulations issued in 2006 (although not yet finalized) effectively eliminated this benefit, requiring you to recognize the gain immediately. It’s still possible, however, to defer capital gain by structuring the transaction as a sale to a defective grantor trust in exchange for the annuity.

Another potential benefit: Because the transferee’s obligation to make the annuity payments ends when you die, your family will receive a significant windfall should you fail to reach your actuarial life expectancy. In other words, your family will have acquired the property, free of estate and gift taxes, for a fraction of its fair market value. On the other hand, if you outlive your life expectancy, your family will end up overpaying.

Keep in mind that private annuities can’t be “deathbed” transactions. If your chances of surviving at least one year are less than 50%, the IRS actuarial tables won’t apply and the transfer will be treated as a taxable gift.

What about risks?

A disadvantage of many popular estate planning techniques is “mortality risk.” For example, the benefits of a grantor retained annuity trust are lost if you fail to survive the trust term. Private annuities, on the other hand, involve “reverse mortality risk.” If you outlive your life expectancy, the total annuity payments will exceed the property’s fair market value, causing your family to overpay for the transferred property and potentially increasing the size of your taxable estate.

To avoid this result, consider a deferred private annuity, which delays the commencement of annuity payments, reducing reverse mortality risk. The U.S. Tax Court has given its stamp of approval to a deferred private annuity. In Estate of Kite v. Commissioner, the court approved a deferred private annuity transaction, even though the annuitant died before the annuity payments began. As a result, her children received a significant amount of wealth, free of estate and gift taxes, without having to make any payments.

There’s also a risk that your child or other transferee will be unable or unwilling to make the annuity payments. Private annuities are unsecured obligations, and if the recipient defaults, the IRS may challenge the arrangement as a disguised gift.

Only part of the package

A private annuity is only one possible element in an estate plan. Consult with your financial advisor to see which strategies work best in your particular situation.

© 2016