The purpose of this article is to address the many benefits that charitable giving provides - from income and estate tax savings to fulfilling personal and charitable goals.
Assume a client has accumulated a $3,000,000 estate. The client expresses a desire to benefit his or her spouse and their 3 children.
After you, the attorney, prepare revocable living trusts for each spouse to protect $1,300,000 from estate tax ($650,000 each), there would still remain a tax of over $700,000.
In order to reduce the remaining tax, you would commonly discuss insurance to pay the estate taxes (the insurance would be owned by an irrevocable trust to avoid additional estate tax on the insurance) and other estate reducing techniques such as gifts under the annual exclusion and lifetime use of the exemption. These techniques would include direct gifts to children, gifts in trust for grandchildren, and family discount limited liability companies. These strategies would generally reduce the estate tax but not eliminate it.
Charitable giving during life offers many income tax and other benefits but typically does not eliminate the estate tax. In contrast, charitable giving at the time of death is an excellent technique to eliminate the estate tax while permitting the client to retain control during his or her life. Assuming, in a 50% estate tax bracket, gifts to charity (assume $100,000) at the time of the death of the surviving spouse will reduce the estate tax by 50% of the charitable gift ($50,000) and the heirs= inheritance by 50% of the charitable gift ($50,000).
In order to eliminate the estate tax, you can structure the estate to provide that any assets in excess of the exemption amount would be distributed to charity. The following chart illustrates the economics of death-time charitable giving assuming: (1) no charitable gift, (2) $100,000 gift, and (3) gift to eliminate the estate tax.
No charitable gift
Reduce estate taxwith $100,000 gift
Gift to Eliminateestate tax
Insurance used to pay estate tax
Insurance used to compensate for $50,000 reduction in inheritance
Insurance used to compensate for $850,000 reduction in inheritance
Paying estate taxes is optional. Rather than paying the estate tax and your client's money being used by the government for its projects, your client can control the public use of the funds by designating a charity or charities of his or her own choice.
"Compensate" heirs. Rather than using insurance to pay the estate tax, the insurance would be used to "compensate" the heirs for the reduction in their inheritance. We have seen "compensation" range from no compensation (under the theory that the net inheritance is enough), to compensation for the reduction of their share ($850,000 in the no estate tax alternative, under the theory that the inheritance of $1,300,000 plus the $850,000 insurance equals the share the heirs would have received had there been no charitable gift - $2,150,000), to full compensation ($1,700,000, under the theory that the children would be able to receive the entire estate tax free: $1,300,000 tax free amount under the current exemption plus $1,700,000 "compensation" = $3,000,000).
Suppose the premium for an $850,000 second-to-die policy for married spouses each age 60 is $9,000. If structured properly the insurance premium constitutes a $3,000 gift to each child (assuming 3 children) under the annual exclusion. The family can still give $17,000 to each child under the remaining annual exclusion.
Heirs' Inheritance. We have found that many times a charitable giving discussion starts with the question, "How much do you want to leave your children?" Sometimes, it is not the primary goal to leave the entire estate to the children. The charity would receive the excess.
Other Reasons. In addition to reducing estate and income tax, clients are motivated to make charitable bequests to increase their cash flow, to diversify their investment portfolio, to benefit the community and to involve their family in philanthropy.
A client can make a direct gift to charity or make a gift and retain some economic benefit. First direct gifts will be discussed, followed by gifts with retained interests. Gifts of life insurance and gifts to a charity as beneficiary of a qualified plan or IRA will then be addressed.
Lifetime Direct Gifts
Outright gift. A client can simply make an outright gift to charity to be used for the general purposes of the charity or dedicated to a special purpose designated by the client. Alternatively, the client can create a donor advised fund or a supporting organization, which are both discussed below. The client receives an income tax deduction for the gift, subject to certain limitations. Capital gain is avoided entirely.
Donor-advised fund. A donor-advised fund is a separate fund established and maintained by a public charity. The fund generally bears the name of the donor. A donor-advised fund is an extremely flexible way to make gifts to charity. For example, your client may create a donor advised fund with a public charity and contribute an asset worth $50,000 on December 31, 1999. The client would take an income tax deduction for $50,000 in 1999, subject to certain limitations. All capital gain is eliminated. In subsequent years, whenever the client wants a recipient charity to receive funds, he or she would make a non-binding recommendation to the board of directors of the public charity, which then would distribute the gift to the recipient charity. There are very few restrictions on donor-advised funds. The fund can last for the client's lifetime or a period of years.
Supporting Organization. A supporting organization is a separate non-profit corporate entity that supports the purposes of the public charity. Supporting organizations are generally require more substantial gifts (some charities require a minimum of $1,000,000). Family members generally serve on the board of the supporting foundation, although they may not control it. Favorable public charity deduction rules apply to supporting organizations. There is no payout requirement as is required with a private foundation.
Lifetime Gifts with Retained Interests
Pooled income fund. A pooled income fund is a trust created and administered by a public charity. The donor contributes funds to the trust which holds funds from many other donors. The donor receives a pro rata share of all the income from the trust which is taxed at ordinary income rates. At the donor=s death, the charity receives the funds.
There is an income tax deduction based on the present value of the remainder interest depending on the beneficiary's age. Capital gain tax is avoided on contributions of appreciated property. Estate tax is eliminated. Many times, pooled income funds are used with smaller contributions when compared to other charitable gifts.
Charitable gift annuity. Your client can create a charitable gift annuity with a public charity by transferring assets to the charity in exchange for an annuity for his or her life and the life of another. The charitable deduction is based on the amount transferred less the present value of the amount retained by the income beneficiary. The annuity rates are based on tables published by the American Council of Gift Annuities. Charitable gift annuities can be structured as either immediate or deferred annuities. The amount of the payout is dependent upon the age of the income beneficiary. A portion of each payment (exclusion ratio) equal to the cost of the annuity over the expected return is considered a tax-free return of principal and therefore not taxed. The balance is ordinary income. Capital gain is reported on the installment method if the donor is an income beneficiary.
Charitable Remainder Trust. A charitable remainder trust ("CRT") involves a transfer of assets to a charity in return for a promise to pay annual income (not less than 5% or more than 50% of the fair market value) for the life of the beneficiary or for a period certain (not more than 20 years). To avoid withdrawing too much from the CRT, the present value of the charitable remainder interest must be at least 10% of the fair market value as of the date of the contribution. If there is more than a 5% probability that the CRT would be exhausted before the charitable remainder vests, the charitable remainder trust fails and no deduction is available.
The donor receives a charitable deduction based on the present value of the charitable remainder interest. The income received from the trust is treated first as ordinary income, followed by capital gain, non-taxable income and then a return of corpus. The entire trust is excluded from estate tax.
The client can also create a CRT effective upon his death. Rather than his or her heirs receiving assets outright, the heirs would receive the income and upon their death or upon expiration of the income term, the balance of the CRT would be distributed to charity.
Charitable remainder trust can be structured as an annuity trust ("CRAT") or a unitrust ("CRUT"). Payments under a CRAT are expressed as a sum certain or a fixed percent of the initial value of the Trust. Payments under a CRUT are expressed as a fixed percent of the annual fair market value. Additional contributions can be made to a CRUT.
A CRT is a perfect vehicle for avoiding capital gains tax and receiving income from the full value of the donated asset. If a capital gain asset is sold outside the CRT, the donor receives less income since only the net proceeds (proceeds less tax) are available for investment. In contrast, if an asset is contributed to a CRT, the full value is available to produce income.
If the asset contributed to the CRUT is non-income producing (example, land), it is not necessary to immediately sell the asset to produce income. A CRUT can be structured to pay the lesser of the actual income or a fixed percent ("NICRUT"). It may also provide that any accumulated deficiency -- if the actual income is less than the fixed percent -- can be paid in later years when the actual income is greater than the fixed percent ("NIMCRUT"). Upon the sale of the asset (at retirement, for example), the proceeds can be invested in income producing assets to generate the desired income.
A concern with the NICRUT or NIMCRUT is that the trustee must invest in income producing assets to pay the income interest. This investment strategy would hurt the charity which would prefer growth in the CRUT rather than the investment strategy used to produce income. As a result, a FLIP unitrust can be structured which provides that at the time of the sale or other triggering event, the unitrust flips to a fixed percent. This permits the trustee to invest in long term growth, since the fixed percent can be paid from both income and principal.
The following chart compares retained interest gifts:
AGE 70 - $100,000 CONTRIBUTED
RETAINED INTEREST GIFTS
Pooled Income Fund
Charitable Gift Annuity
7,000 per year
7,500 per year
Income tax treatment
1. ordinary income
2. capital gain
4. return of
Part tax free
53% = 3,975
47% = 3,525
Yes - installment basis over life expectancy
Charitable lead trust. A charitable lead trust ("CLT") usually provides income for a charity for a certain term, followed by a distribution of the assets to the client or his family. A donor could create a CLT to benefit a university for a 4-year college term with the remaining amount then distributed to his children. The non-charitable interest can be structured for the life of the donor or his family or for a term.
donor generally receives an income tax deduction (if the trust is a grantor trust) for the value of the charitable lead interest. If the non-charitable beneficiary is someone other than the donor, the present value of that amount is a gift. This permits the donor to pass assets to his or her family at a reduced tax cost. The donor is taxed on the trust income (if a grantor trust) even though the charity receives the funds. The donor receives an estate tax deduction based on the present value of the gift to charity.
Special Gifts - Life Insurance and Qualified Plan Assets
Gifts of life insurance. A client can leverage a small contribution into a large gift by gifting a life insurance policy to a charity. If the policy is irrevocably assigned to the charity, the client receives an income tax deduction for the premiums paid and for the replacement cost (policy still in force) or the cost of a single premium contract (paid up policy). There is a 100% estate tax deduction.
cally, the client makes the first premium payments and then assigns the policy to charity. The client continues the payments to charity which then makes the payments to the insurance company.
Charity as beneficiary of qualified plan or IRA. This strategy is selected for special attention because of its benefits and its ease in creation and administration. The donor simply designates the charity as the primary or secondary beneficiary (the spouse would be primary beneficiary) of his or her qualified plan or IRA. The donor and his or her spouse use the funds during their lifetime. At death, the charity receives the entire benefits. No further income tax is due and the donor receives a 100% estate tax deduction. If the IRA or qualified plan is paid to a noncharitable beneficiary, the taxes can be more than 75% of the total assets, since the assets are subject to both income tax and estate tax. Many times this technique is used in conjunction with a wealth replacement trust.
Type of Charity - Public Charity or Private Foundation
s to charity during life and at the time of death can be made either to a public charity or a private foundation or both. The benefits of a private foundation are its flexibility with respect to the selection of charitable beneficiaries, control over the investments and family involvement. Public charities are commonly used because of the ease of administration (no reporting requirements), and the use of their professional staffs in managing the assets and providing information regarding charitable beneficiaries.
rally, public charities receive more favorable income tax treatment than private foundations, although private foundations can be structured to enjoy the same tax benefits as a public charity.
ate foundations are subject to certain excise tax provisions which can be addressed with proper planning.
Tax Deduction Rules
following chart is an illustration of the income tax deduction rules for public charities and private foundations. The tax deduction depends upon the identity of the charity and the nature of the contributed property:
Income Tax Deduction Rules
- Public charity/Pass through Foundation
- Private Foundation
Limitation against Adjusted Gross Income - cash
Fair market value ("FMV")
FMV for cash and publicly traded stocks (other appreciated property limited to basis)
5 year carryover
There is significant competition for charitable gifts - from hospitals, schools, medical research facilities and many other organizations. It is important that the identity of the charity be explored as well as the proper structuring of the gift so that your client's goals are achieved.