Efficient Charitable Gifting: A Planned Giving Primer

This article is written to provide a very basic approach for individuals involved in the estate planning process considering including a charitable bequest in their estate plan. Technical analyses and references to statutes have been omitted. For a detailed understanding of a proposed charitable bequest, please see your estate planning counselor.

From Andrew Carnegie to Bill Gates, philanthropic legacies formed a large part of American civicism in the 20th Century. At the dawn of the new millennium, planned gifts (gifts and bequests from individuals to charities as part of a comprehensive estate plan) will become ever more popular and comprise a larger percentage of revenue for the non-profit sector.

Gifts can be given inefficiently or efficiently. Efficiency is a factor of tax and economic consequences to the giver and accountability of the recipient charity/non-profit. This article addresses the first of these concepts: tax and economic efficiency of the gift.

Tax Efficiency of the Gift

Assume Husband and Wife Phil and Ann Thropist own a parcel of raw land in an unincorporated area of a Bay Area suburb (e.g., Pleasanton or Fremont). It was acquired in 1965 for $10,000. Because the suburb has developed around the parcel, it is now in-fill and worth several hundred thousand (if not millions) of dollars.

Option A: Sell the Property and Donate the Proceeds

If Phil and Ann sell the property and donate the proceeds to charity, they will have engaged in a tax-inefficient gift. This means that they have structured their gift in a way that does not take optimum advantage of tax laws. Had they correctly structured their gift, the net result would have been a six-figure tax savings.

Here's why: in selling the property, say for $1.01 million, they will recognize a $1 million long-term capital gain. They will be taxed at the 15% federal and 9.3% state bracket on this gain. Further, the gain will increase their Adjusted Gross Income (AGI), which will, in turn, limit their itemized deduction for the year in question, resulting in an effective combined marginal rate in the range of 25%. Thus, they would owe approximately $250,000 more in taxes after the sale than they would have owed without the sale.

They then seek to deduct the $1.01 million charitable contribution on Schedule A to offset this gain. However, this Schedule A charitable deduction is said to be below the line (after AGI is first calculated) and thus less valuable, from a tax perspective, than a reduction in their AGI (above the line) would have been. This is because the itemized charitable deduction is limited to 50% of their AGI and further reduced by 3% of their AGI above a certain income threshold (because the gain placed their income in an extraordinarily high tax bracket).

Option B: Contribute the Property and Let the Charity Sell It

Phil and Ann could also contribute the property directly to their charity of choice, and allow the charity to sell the property. In this scenario, the gift is said to be more tax efficient because the sale, if it occurs, takes place inside the charitable organization, a non-profit entity, where no income taxes are payable on the gain. Also, Phil and Ann are allowed to deduct the fair market value ($1.01 million) on the contribution under the Tax Code. Thus, they do not have to recognize the gain on sale and further can deduct the value of the contribution over the next five years (they deduct a maximum amount each year and carry forward for deduction in later years the amount not deductible -- for up to five years).

Other Options

Good tax attorneys and financial advisors could suggest a number of other options that would maximize the tax benefit to Phil and Ann. These might include one or a combination of the following techniques: a contribution of a fractional interest in the property only, followed by a sale, a contribution to a charitable trust of some sort, such as a charitable lead trust or a charitable remainder trust, an exchange of the property for a charitable gift annuity, or a bequest in their estate plan to a charity or a charitable trust.

Economic Efficiency of the Gift

Another factor in determining how to plan a gift is its economic efficiency. Some assets generate lots of positive cash flow and are unsuitable as charitable holdings. For example, an ongoing business would not be appropriate. This is because an ongoing business that generates income would create UBTI for the charity (unrelated business taxable income), which would either disqualify the tax-exempt status of the charity (in the case of a charitable trust or family foundation) or trigger taxation to the charity (in the case of a public charity). The tax code treats these assets differently because charities are supposed to hold investment assets, not run businesses. Further, such an asset is usually better off being owned by the family running the business, which has the experience and collective memory necessary to keep the business profitable.

The most economically efficient assets for gifting are assets that generate no income and are worth more sold and converted to cash than they are worth as revenue-generators. Highly appreciated stock with low dividend yields, raw land, and tangible personal property often fit well into this principle.

Evaluating the Ideal Option

To determine which option has the greatest tax efficiency, the Thropists will want to evaluate the ratio of their cost to the benefit to the charity. For example, if their after-tax cost is $250,000 and the benefit to the charity is $1 million, their charitable-giving ratio is four to one (4:1). If their cost is $250,000 and the benefit to the charity is $500,000 (if they contribute 50% of the asset to the charity), then their charitable-giving ratio is said to be two-to-one (2:1). If they actually are better off economically by making the charitable gift, such that there is no cost but rather an economic benefit to the family, then we call that a home run.

Can a client's family be better off with a charitable gift than without one? The answer, oddly, is yes. This usually happens when an asset has a built-in gain that results in ordinary income taxable to the recipient or beneficiary. Examples of such assets would be assets generating royalty income, interest on promissory notes, qualified retirement accounts and IRAs, non-qualified stock options, and annuities. However, in many instances, the immediate gift of such assets to a charity during lifetime will trigger imputed recognition of income to the donor under the assignment of income doctrine. The solution in this scenario is to leave the asset to the charitable trust at the death of the owner, with the family members in place as the non-charitable beneficiaries of the charitable trust and the charity (or, even better, a family foundation) as the remainder beneficiary of the trust.

Looking for Assets that Provide the Best Opportunities for Planning Giving

Certain assets provide ideal assets for charitable planning. Capital assets, such as real estate, tangible personal property, and publicly traded stock can provide such opportunities when their fair market value (what they are worth in an arms-length sale) is much larger than their tax basis (generally, the amount that was paid for the asset). Income assets, such as those listed above, can provide excellent testamentary (after death) bequests to charity, because the non-charitable recipient of the gift would have to recognize ordinary income upon receipt of the asset or the funds generated by the asset. Such income assets are called income in respect of a decedent (IRD) assets by tax professionals. The chart below illustrates the ideal assets to consider using when making outright gifts or testamentary bequests to charities:

Assets Most Tax-Efficient for Lifetime Gifts

1. Capital assets with lots of appreciation (built-in gain):

a. Publicly-traded stock
b. Tangible personal property, such as artwork or items suitable for exhibition in a museum
c. Real estate (generally with little or no debt)

Assets Most Tax-Efficient for Testamentary Gifts

1. IRD assets

a. Non-qualified stock options
b. Qualified retirement accounts (e.g., 401(k)'s)
c. IRAs
d. Deferred Variable Annuities with significant built-in appreciation
e. Promissory notes
f. Royalties or properties generating substantial royalties

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