Many individuals have charities or causes that are important to them, and they naturally want to support these causes. Charitable giving is of particular interest to those who may not have anyone to inherit their legacies or those who are motivated by income or estate tax minimization. There are many ways to give, either during life or after passing, and each has distinct benefits and considerations. This article explores the most common gifting strategies.
In addition to philanthropic wishes, lifetime charitable gifts can be used to minimize or offset income tax. These can be handled in several ways.
Cash, Real Estate, or Personal Property
The simplest gifts are donations of cash, real estate, or personal property (i.e., a car). Those gifts generate an immediate income tax deduction and remove those assets from a future taxable estate. A charitable gift does not need to be reported on a gift tax return, even if that amount surpassed the annual gift tax exclusion (currently $17,000).
Stocks or other Appreciated Items
When purchasing stock, bonds, or other valuable interests, the buyer obtains a “basis,” the value for which the item was obtained. For example, if Alan purchases 100 shares XYZ stock in 1990 for $10/share (total value of $1,000) and he sells this stock in 2023 at $100/share (total value of $10,000), there will be a taxable capital gain based on Alan’s basis and the sale price. His basis for this sale would be the original value of $10/share, or $1,000. The gain would be the difference between his basis and the value for which he sold the stock – meaning a gain of $9,000 – all of which is taxable. The maximum federal capital gains tax rate is 20% on long-term (more than a year) holdings, and many states impose their own separate capital gains tax.
When a person passes away leaving assets that have appreciated in value, the beneficiary gets a “step-up” in basis. This means that if the XYZ stock went to a beneficiary upon Alan’s passing, its value would be whatever it was on Alan’s date of death, and his beneficiary would inherit the asset with that step-up in basis. However, if Alan gifted assets during his lifetime, the beneficiary would assume Alan’s basis instead of receiving this step-up. If the beneficiary later sold the gift, it would incur the same amount of tax as if Alan sold the asset himself.
This concept does not apply to charities because they are “tax-exempt,” meaning they do not have to pay tax on realized capital gains. Rather than selling an appreciated asset and donating the proceeds to charity, it is advantageous to gift the appreciated asset itself to the charity. Additionally, donors may claim the fair market values of gifts as immediate income tax deductions on their tax returns.
Qualified Charitable Distributions from IRAs
After age 70 ½, a donor may make gifts of up to $100,000 per year directly from an IRA to a charity (NOTE: this does not apply to gifts made from proceeds of IRAs, only gifts directly from the custodian of the IRA to the charity). While this does not generate an income tax deduction, it does satisfy a required minimum distribution and is never taken into income. Therefore, the practical effect is similar to an “above the line” income tax deduction, which can be especially powerful for individuals who take the standard deduction.
There are several types of gifts that not only benefit a charity but also provide the donor or a beneficiary with a stream of income. The two most common income-producing gifts are Charitable Remainder Trusts and Charitable Gift Annuities.
These gifts operate similarly: a donor gifts an amount of money and takes an immediate income tax deduction based on several factors, including the age of the annuitant(s) and the prevailing interest rates. The donor (or another beneficiary) then receives a stream of income for life or for a term of years. When that term is up, the balance goes to the chosen charity, removing the gifted assets from the taxable estate.
Charitable Gift Annuities (CGAs) are contracts between a donor and a charity. The charity holds the gift and provides the stream of income back to the donor. These are relatively simple to set up and can be appropriate for gifts between $25,000 and $1 million.
Charitable Remainder Trusts (CRTs) may be appropriate for larger gifts, typically gifts over $1 million. While similar in concept to CGAs, charitable remainder trusts provide more flexibility and control. For example, the donor gets to select the trustees, and those trustees can choose how to manage the assets instead of the charity. The donor can also benefit multiple charities, whereas CRTs typically only benefit a single organization.
Charitable Lead Trusts
Charitable Lead Trusts are the inverse of Charitable Remainder Trusts. The charity receives the stream of income over the set term, and the balance is distributed to beneficiaries, such as a spouse, children, or other individuals, at the end of the term.
The tax benefits for a charitable lead trust depend on whether it is a “grantor” or “non-grantor“ trust (a grantor trust being a trust over which a donor retains certain powers). If the charitable lead trust is a grantor trust, a donor may take an immediate income tax deduction for the present value of future payments that will be made to the charitable beneficiaries (less some deductions). A non-grantor charitable lead trust does not allow the same liberty of taking the income tax deduction on a personal tax return, but rather the trust itself is able to claim an unlimited income tax charitable deduction for its distributions to the charitable beneficiaries.
Gifts at Death
Often, donors choose to defer giving until their deaths because a) gifts may be substantially more than they can part with during lifetime b) they can continue to enjoy and control their assets, and c) they can amend the gifts during their lifetimes.
For those with taxable estates, charitable gifts at death can be a powerful tool to minimize estate taxes. While there are many gift planning strategies, the most common are as follows:
By Will or Revocable Trust – Cash, Real Estate, or Personal Property
Gifts made under a Will or Revocable Trust are flexible; a donor can specify not only the charity but the purpose of the gift. For example, a donor may leave $10,000 to a university but designate it solely for the endowment fund.
Retirement accounts are beneficiary-designated assets, meaning that donors direct who inherits the accounts upon their passing. Beneficiaries may be anyone they choose (NOTE: some retirement accounts require donors to name a spouse primarily or require a spouse’s waiver should the spouse not be named).
When a beneficiary (other than a spouse or other qualified individuals) inherits a retirement account, the beneficiary typically has 10 years from the date of inheritance to withdraw the total funds. As most retirement account proceeds are subject to income tax, this means a beneficiary can also inherit a sizeable tax bill.
As such, clients who include charitable giving as part of their estate plans often choose to leave their retirement accounts to charities, since charities do not pay this income tax. This means that the full value of the retirement account will directly benefit the charity, rather than if a non-charity individual inherited the account and paid taxes on it.
Since the SECURE Act was adopted in 2019, some have found designating a Charitable Remainder Trust as the beneficiary of a retirement account to be a particularly attractive strategy. This can allow a beneficiary to receive a stream of income for life (as opposed to the 10-year payout) while still ultimately benefiting a charity.
Donor-Advised Funds and Charitable Foundations
Some clients are charitably inclined but cannot immediately identify a charity. Some want to set up an organization that provides a lasting legacy. And some want to pass along their philanthropic values to the next generation. For these clients, an appropriate tool might be a Donor-Advised Fund or Charitable Foundation.
A Donor-Advised Fund (DAF) is a charitable fund, typically administered by a financial institution or community foundation. A donor sets up an account at a DAF and makes a gift with the same characteristics of a gift to any other charity. Then, at some later point, the donor can direct the DAF to make distributions from the account to a qualified charity. The donor can include family members or other individuals as successor advisors to help pass on this legacy of giving. DAFs are typically easy to set up and inexpensive to run.
Charitable Foundations are charities set up for a charitable purpose during a donor’s lifetime or upon a donor’s death. Most charitable foundations are not “operating foundations,” meaning their purpose is to serve as a source of funds for public charities and not to do charitable work themselves. Foundations have a litany of rules they must follow and can be expensive to set up. However, they offer maximum control and flexibility for donors and their families.
For more information on the benefits of charitable giving, both during your lifetime and upon your passing, please contact a member of our Estate Planning group.