Giving to your favorite charities can be personally rewarding; it can also provide significant savings in income and estate taxes. In addition to the well-known charitable deduction for contributions to 501(c)(3) nonprofit organizations, further tax savings can be obtained through carefully planning the timing and form of your donations. Strategic charitable planning maximizes your tax savings while providing you with the utmost control over how and when your money is spent.
Donations of Appreciated Property
When you donate certain appreciated property instead of cash, you not only enjoy an income tax deduction equal to the value of the donated property, but you also avoid paying capital gains taxes on the amount of the appreciation. To illustrate, if you bought stock for $1,000 5 years ago, and the stock is now worth $9,000, you can donate the stock to charity and claim a $9,000 charitable deduction. The charity would sell the stock and receive $9,000 to use in its work. However, if you sell the stock, and then donate the proceeds to charity, you would pay $1,200 in capital gains tax and the charity would receive only $7,800. Meanwhile, your deduction is limited to the $7,800 that was ultimately received by the charity. By simply altering the form of the donation, the charity receives an additional $1,200, your deduction increases by $1,200, and you avoid $1,200 in tax payments –a win-win for both parties.
Charitable Lead Trusts
A Charitable Lead Trust (CLT) generates an income stream for a nonprofit organization of your choice for a certain term. At the end of the term, the remaining assets are distributed to family members or other beneficiaries.
In a low-interest rate environment like we are currently experiencing, a certain type of Charitable Lead Annuity Trust (a zeroed-out CLAT) may be effective in transferring property to non-charitable beneficiaries free of estate and gift tax. In a zeroed-out CLAT, the taxpayer sets up a trust that pays a charity a percentage of the amount placed into the trust, based on a minimum rate established by the IRS and based on the Applicable Federal Rate then in effect. If the trust principal earns more than the amount paid out to the charity, the remainder is transferred to the non-charitable beneficiaries free of gift or estate tax.
For example, suppose you set up a trust with $2 million that pays $175,000 per year for 15 years to a charity, with any remaining money distributed to your children. Using the IRS’s 3.6% rate, the present value of the charitable payout equals $2 million, the amount placed into the trust. In other words, if the trust earns an annual 3.6% return, it will run out of money after 15 years, leaving no money for the children. If, however, the trust earns an annualized 7% per year, $1.12 million is distributed to the children free of gift or estate tax.
Charitable Remainder Trusts
A Charitable Remainder Trust (CRT) lets you convert a highly-appreciated asset into lifetime income while reducing income and estate taxes. The CRT is often a good option for charitable individuals who own a highly-appreciated asset, such as stock in their business, and want to ensure an income stream for their lifetime.
In a CRT, you transfer an appreciated asset to a charitable trust, and the trust sells the asset to a third party. Because the trust is a charitable entity, there is no capital gains tax due on the sale. The trust then pays a percentage of the trust funds to you for the rest of your life, and if desired, for the life of another family member. The amount remaining in the trust at the end of the term is transferred to the charity of your choice. In the year the asset is transferred, you are entitled to a charitable deduction against your income taxes in the amount that will inure to charity.
If you would like a portion of the money to be given to your children, you can use the tax savings and higher income payment to fund a life insurance policy that would provide your children with the same amount that the trust pays to the charity.
There are many tax benefits of a CRT. First, you avoid capital gains tax on the sale of the asset. As a result, the income generated by the sale proceeds is higher than if you had sold the asset, paid taxes on the gain, and invested the proceeds. You also receive an income tax deduction in the year the asset is transferred to the trust in the amount of the present value of the interest that will be left to charity.
To illustrate, suppose you own a successful business that you started 40 years ago. Your original investment in the company is $100,000, and the company is currently worth $10 million. You have decided to sell the business and use the proceeds of the sale to retire and travel the world.
Assume that, without advanced planning, you sell the stock to another party and pay $2.36 million in capital gains tax. You then invest the proceeds of $7.64 million, at a rate of return of 6%, and live off the annual income of $460,000. You plan to leave the amount remaining in the investment account to Do-Good Charity upon your death. In this scenario, you receive an annual payment of $460,000 for your life, you receive no income tax deduction, and Do-Good Charity receives a gift with a present value of about $1.33 million (assuming a term of 30 years).
Now suppose, instead, you transfer the company stock to a CRT. The trust sells the stock for $10 million. Because it is sold by a charitable trust, there is no capital gains tax. The trust invests the sales proceeds of $10 million and pays you 6% of the value of the trust every year, which, assuming a 6% rate of return, yields $600,000 annually. You are entitled to an income tax deduction in the amount that will ultimately be transferred to Do-Good Charity ($1.74 million in present value terms), generating income tax savings of about $690,000 in the year the asset is transferred to the trust. Compared to the previous example, your annual payment is almost $140,000 higher, and you benefit from an income tax savings of $690,000. Furthermore, the value of the gift to Do-Good Charity is $1.74 million – $410,000 more than in the first scenario.
If you wish to leave the remainder amount to your children, you could simply use the $670,000 in income tax savings and a portion of the higher investment income to fund a life insurance policy for your children. This structure allows you to provide for both your children and your favorite charity at no or nominal increased cost over leaving it to your children alone.