By Alan G. Orlowsky, J.D., C.P.A.
“Charity begins at home” is an appropriate maxim for most people who are struggling to raise their children, support their families, and save for their retirement. But for those who are fortunate enough to have the necessities of life and the resources to provide for a rainy day, philanthropy is an affordable and gratifying option.
When discussing the tax consequences of charitable giving with a client, I usually advise, if possible and affordable, that they should make donations during their lifetime, rather than at death. The purpose of this advice is two-fold:
For example, if you are an 80-year-old individual with a $15 million dollar estate, you fall into the 40% estate tax bracket. If you make a $100,000 gift to charity this year, your income tax savings is approximately $35,000 (assuming a 35% income tax bracket). If you then die in 2020, at that time there is $65,000 ($100,000-$35,000) less in your estate because of the gift in 2007, and therefore an estate tax savings of $26,000. The aggregate tax savings is $61,000 ($35,000 plus $26,000). If you had waited until your death to make the gift, the tax savings would only be $40,000 (40% of $100,000). Thus, by making donations while you’re still alive, you realize an additional $21,000 that you can give to your family. By giving now you can have your cake and eat it too.
If you are not ready to make an outright gift during your lifetime, you may consider establishing a charitable remainder trust (CRT). With the CRT you can make a charitable contribution to the trust at any time. The assets in the trust will go to the charities of your choice after your death, but during the remainder of your lifetime you will retain income from the donated asset! Still, you are permitted to take an income-tax deduction for the year in which you make the donation.
Better yet, a CRT lets you sell highly appreciated assets, such as a low-yielding stock, free of capital gains tax, and turn it into a lifetime income stream. Here’s how it works:
To establish a CRT, you either visit your attorney who will help you draft the trust document, or contact the selected charity — some charities will set up the trust for you and cover the cost of doing so, as long as they are the designated beneficiary.
The trustee then sells the donated assets at fair market value (incurring no capital gains tax liability), and reinvests the proceeds in income-producing assets such as corporate bonds, say at 7 percent interest. For the rest of your life, and that of your spouse if you so desire, the trust pays you the interest income. When you die, the remaining trust assets pass to the charity or charities you have selected.
In this way, the CRT allows you to reduce your income taxes now, avoid capital gains taxes, and reduce estate taxes upon your death. More importantly, it allows you to give more to a charity or charities that have special meaning to you, all at the expense of the IRS!
Another vehicle for making charitable gifts, either during your life or subsequent to your death, is the charitable foundation. Individuals and corporations establish charitable foundations for a number of reasons:
Although the benefits of foundations are significant, there are considerable administrative and regulatory requirements. Large foundations are subject to yearly audits. All foundations must file IRS Form 990 each year, which includes both financial and administrative information. Furthermore, there are restrictions on self-dealing, conflicts of interest, political activities, etc.
For smaller estates and smaller gifts to existing charities, a foundation is not the recommended vehicle of choice. Unless your gift is greater than $500,000, I do not advise the creation of a foundation because, unless the funds are substantial, the burdens of administration outweigh the benefits of creation.
There is a way to enjoy many of the benefits of a charitable foundation while avoiding the administrative hassles. Donor-advised funds (DAFs) are charitable accounts that you establish in your name (like naming your own foundation), but the funds are held by an organization such as a community foundation, university, religious federation, public charity, hospital, or trust company. More recently, brokerage firms have established DAFs for their clients. A popular community foundation in the Midwest, for example, is the Chicago Community Trust.
Your DAF is a component of the organization, which administers the funds and makes the grants to charities. You can recommend which charities it should distribute the funds to, but the organization is not obligated to follow your recommendations. For that reason, you should choose an organization that routinely donates to charities that you favor.
DAFs typically require a minimum initial donation of anywhere from $1,000 to $250,000. You can make subsequent contributions — which are irrevocable — at any time, typically in increments of $1,000. You enjoy an immediate income tax deduction for your donation, even if the DAF does not make a grant in the same year. In addition, funds in your DAF are not included in your estate for tax purposes. And like a CRT, you may avoid paying capital gains tax on appreciated assets that you donate.
If you are considering donating large sums of money to one or more charitable organizations, you should meet with your attorney or accountant to determine the best tax strategies for making such gifts. The laws in this field are complicated. Choosing the proper strategy will not only allow you to leave more money for family members, but will also allow you to pass on more to your favorite charities.
Here’s an example that illustrates the generous tax advantages of a charitable remainder trust (CRT). Fred and Irma, ages 72 and 73, are planning to retire next year but need a steady stream of income. About 30 years ago they purchased stock in Microsoft for $20,000, and now it is worth approximately $500,000. The stock pays a small dividend, so they would like to sell it and then purchase corporate bonds with the proceeds. Upon their deaths, they would then like the remaining funds to go to their favorite charity.
In Scenario A, Fred and Irma sell the stock without the use of a CRT. A capital gains tax of approximately $100,000 is due, which would leave them with $400,000 after the sale. If they invest the remaining funds in bonds yielding a 6 percent return, they would have a yearly income of $24,000 (6% of $400,000).
In Scenario B, they donate the entire $500,000 worth of stock to a CRT. The CRT sells the stock and buys bonds yielding 6 percent. No capital gains tax is due. Fred and Irma would have a yearly income of $30,000 (6% of $500,000), which is $6,000 more than if they had not used a CRT. Moreover, the charity gets $100,000 more than in Scenario A ($500,000 – $400,000), and the couple enjoys a larger charitable deduction on their income tax return for each year they make a donation to the CRT. This is truly a win-win situation for all parties except the IRS.
Alan G. Orlowsky, President of Orlowsky & Wilson, Ltd. in Lincolnshire, Illinois, has been counseling people on estate planning for over 30 years. He previously worked for the IRS in its Estate and Gift Tax Division. He also worked for the Deloitte & Touche accounting firm, and he has taught taxation and accounting at the Loyola University of Chicago, School of Business.
Al is a contributing author of the book 21st Century Wealth (Esperti Peterson Institute, Denver, 2000), and has written numerous articles on the subject of estate planning. Contact Alan Orlowsky by email or call 847-325-5559.
Updated January 2020