We take our lead from Groucho Marx: “Before I speak, I have something important to say.”
Americans will continue to support charitable organizations no matter who wins the upcoming election. However, many donors will consider the after-tax cost of their charitable contributions. Yet, for some taxpayers, tax savings are looked on not as reducing the cost of generosity but as a way of increasing their charitable gifts.
Possible Tax Law Changes
What are some tax law changes that could/would affect how, or whether, taxpayers make charitable gifts?We look to Nostradamus.The French astrologer, physician and seer made his predictions back in 1555. He predicted—depending on the outcome of the November 2020 U.S. elections—drastic changes could be made in the U.S. income, gift and estate tax laws. He hedged on who would win, but did foresee if a certain individual were to win the presidency, the below changes could take place retroactively to Jan. 1, 2021.
Those new laws would change the out-of-pocket costs and timing of making lifetime and deathtime charitable gifts. And, current family gift and estate tax saving techniques would be weakened or lost for wealthy individuals.
Income tax changes. These include:
Current 37% top rate would return to prior 39.5% top rate.
Capital gains and domestic dividends would be taxed at ordinary income tax rates (instead of the lower, current rates) for individuals with annual income over $1 million.
Itemized deductions, including charitable deductions, would, for individuals in the high tax brackets, be capped at the 28% bracket.
“Carried interest” for “hedge fund individuals” would be taxed as ordinary income.
Tax-free exchanges for commercial real estate would be repealed. (Apparently, Nostradamus had an inkling of the opposing presidential candidate.)
Gift and estate tax changes. These include:
The 2020 unified $11.58 million gift and estate tax exemption (indexed for inflation) scheduled to revert to $5 million (indexed for inflation) in 2026 could revert to that amount in 2021.
Worse still (for those who have to pay), the unified gift and estate tax exemption could revert to the $3.5 million exemption of yesteryear.
Appreciated assets would no longer get a stepped-up basis at death.
Sophisticated gift and estate tax saving plans for wealthy individuals would be weakened or repealed.
The Basics
To get charitable deductions, many requirements must be met, and the Internal Revenue Service insists on strict (not substantial) compliance. For income, gift and estate tax charitable deductions, gifts must be made to an Internal Revenue Code Section 501(c)(3) tax-exempt organization. A good way to meet this requirement: Go to “Tax Exempt Organization Search” on the IRS’ website. You can search a charity’s tax status by the organization’s name or taxpayer identification number. Now that you have a qualified charity, gifts must be substantiated. The rules are specific, must be meticulously followed and no second chances are allowed.1
The amount of a donor’s income tax charitable deduction depends on: (1) the identity of the donor (individual or corporation); (2) the tax status of the recipient charity (public charity (PC) or private foundation (PF)); (3) the adjusted gross income (AGI) of an individual donor and the taxable income of a corporate donor; (4) an individual’s AGI in any carryover years and a corporation’s taxable income in any carryover years; (5) the type of property contributed (cash, ordinary income property, capital gains property, tangible personal property); and (6) other donor gifts made in the same tax year. With a minor exception discussed below, the donor must itemize her deductions.
For individuals, the deductible amount is limited to a percentage of the taxpayer’s contribution base (the donor’s AGI computed without regard to any net operating loss carryback, hereinafter referred to as the donor’s AGI).2 Charitable contributions exceeding the AGI limitations generally may be carried forward for up to five years, usually subject to the same AGI limitation that applied in the year of contribution.3 A donor must claim charitable contributions for the current year before using carryover amounts from prior years.4
The income tax charitable deduction the donor receives is subject to ceilings of 60%, 50%, 30% or 20% of her AGI with the benefits generally being greater for gifts to PCs than for gifts to PFs.5
Exception to 50% or 60% ceilings and 5-year carryover. Conservation easement tax benefits for farmers and ranchers are even greater: 100% of the AGI ceiling with a 15-year carryover.6 This isn’t a misprint. When these special benefits for farmers and ranchers were enacted, Sen. Charles Grassley (R-IA) and Sen. Max Baucus (D-MT) were chairman and ranking member, respectively, of the Senate Finance Committee. They got along famously. The legislative history of this special benefit for farmers and ranchers is best explained by the Rogers and Hammerstein’s song in the musical “Oklahoma”: “Oh, the farmer [Grassley, Iowa] and the cowman [Baucus, Montana] should be [were] friends.”
AGI of 60%. The Tax Cuts and Jobs Act (TCJA) increased the AGI deductibility ceiling for cash gifts to PCs from 50% to 60% with a 60% AGI 5-year carryover for any “excess.”7 However, some, including the American Institute of Certified Public Accountants (AICPA), read the statutory language as providing that deduction is available only if a donor makes all her donations in cash. The AICPA recommends a technical correction to the statute for the limitation to function as Congress intended. Not everyone agrees with the AICPA’s interpretation, including Gordon Clay, the Legislation Counsel on the Joint Committee on Taxation.8
Non-itemizers under the TCJA. Individuals are required to itemize their deductions to qualify for income tax charitable deductions. But, given the increase in the standard deduction (currently $12,400 or $24,800 for joint filers) under the TCJA and the $10,000 limit on the state and local taxes deduction, many individuals who previously itemized no longer do so. Thus, they don’t qualify for the income tax charitable deduction. But read on, and you’ll learn a way a non-itemizer can obtain limited tax benefits for charitable gifts.
The CARES Act
The Coronavirus Aid, Relief and Economic Security (CARES) Act provides that individuals who don’t itemize can deduct $300 in cash gifts to publicly supported charities during 2020 only. Query: Can non-itemizing spouses filing a joint return claim a $600 combined income tax charitable deduction? The Joint Committee on Taxation’s Explanation of the CARES Act states that only $300 is deductible on a joint return; the deduction applies to the tax filing unit.9
Pay attention to the charitable recipient. The $300 “above-the-line” deduction10 applies only for cash gifts to PCs. It doesn’t include contributions of non-cash gifts, such as publicly traded stock.11 It also doesn’t include contributions to donor-advised funds (DAFs), supporting organizations (SOs) or charitable remainder trusts (CRTs).12
Caveat. The substantiation rules for cash gifts presumably apply to the $300 above-the-line deduction if the cash gift is to a single charity and is $250 or more. The donor will presumably need a contemporaneous written acknowledgment from the charity to substantiate the charitable deduction. Regardless of the size of the cash gift, the donor should also record the contribution by saving a canceled check, bank or credit union statement, credit card statement or a written communication (including electronic mail correspondence) from the charity showing its name, amount of the contribution and the date of receipt.
Additional tax incentives for itemizers in 2020. Itemizers may deduct up to 100% of their AGI for cash gifts to PCs, but not to DAFs, SOs or CRTs.13 As with the $300 above-the-line deduction, non-cash contributions don’t qualify. Cash gifts made in years before 2020 that are eligible for a deduction in 2020 because of carryover rules don’t qualify for the 100% of AGI ceiling. The funds must actually be contributed to a qualified PC in 2020. For cash gifts exceeding 100% of AGI in 2020, the “excess” is eligible for the normal 5-year carryover rules, but the earlier percentage AGI limits will apply (presumably up to 60% of AGI). Lastly, donors must elect to apply the 100% of AGI deductibility ceiling. Again, presumably the IRS will issue guidance on how to accomplish this.
Increased incentives for pass-through entities. The CARES Act also increases income tax charitable incentives for charitable gifts by pass-through entities—partnerships and S corporations (S corps). The deduction typically passes through to the partner or shareholder on a Schedule K-1 and is taken at the individual level. Thus, the election to increase the ceiling for cash contributions in 2020 will be made by the partner or by the individual S corp shareholder.
For C corporations (C corps), the charitable deduction is taken at the corporate level. The corporation’s cash gift deductibility ceiling in 2020 is 25% of its contribution base14 (an increase from the 10% ceiling). Same as for individuals; corporations must make an election to increase the contribution base ceiling. Presumably, the IRS will issue guidance on making the election.
The deductibility ceiling for charitable gifts of food inventory by C corps is also increased—from 15% to 25% of taxable income (for 2020 only). The carryover rules for C corps generally follow the carryover rules for individuals.
PFs. Contributions to most PFswon’t qualify for any of the increased charitable deduction ceilings. But, contributions to private operating foundations and pass-through (conduit) foundations15 do qualify.
Cash vs. securities. Will the CARES Act change how people give in 2020—giving cash instead of highly appreciated long-term securities to public charities? Gifts of highly appreciated securities still provide a double tax benefit, typically a deduction based on the asset’s fair market value (FMV) on the date of contribution and the avoidance of any built-in capital gains (the difference between the donor’s basis in the stock and its FMV on the date of contribution). Donors will weigh the increased deductibility ceiling for cash gifts against the benefits of gifts of appreciated securities.
What’s our opinion? We’re reminded of the fellow who before going to law school had a three-word answer to tough questions: “I don’t know.” After practicing law for many years, he still has a three-word answer to tough questions: “Well it depends.”
Other Changes
Leave-based donation programs. The IRS approves employer leave-based donation programs. Historically, the IRS has authorized leave-based donation programs for natural disasters, such as hurricanes. Under those programs, employers allow their employees to forfeit paid vacation, sick days or personal days in exchange for cash payments that the employer donates to charitable organizations.
Notice 2020-4616 provides that when those cash payments are made in 2020 to assist victims of the coronavirus pandemic, employees aren’t treated as having received gross income. Thus, the value of the donated leave isn’t subject to payroll or income taxes. But, the employees can’t take income tax charitable deductions for the value of those contributions. Employers can, however, deduct the payments as charitable contributions or business expenses.
The SECURE Act
The Setting Every Community Up for Retirement Enhancement (SECURE) Act17 eliminates the “stretch” individual retirement account for most heirs. Until this new law, an heir could generally have required minimum distributions (RMDs) stretched over her life expectancy. That minimized taxes; plus, the assets in the heir’s IRA grew tax-free until withdrawn.
Highlights. The new law’s highlights—effective as of Jan. 1, 2020:
RMDs start at age 72 (up from 70½). Why? According to the House Ways and Means Committee, the policy behind the age 70½ rule is:
to ensure that individuals spend their retirement savings during their lifetime and not use their retirement plans for estate planning purposes to transfer wealth to beneficiaries. However, age 70½ was first applied to retirement plans in the early 1960s and hasn’t been adjusted to take into account increased life expectancy. Thus, the law increases the RMD age from age 70½ to 72.18
Most heirs’ IRA payments can’t be stretched out for more than 10 years.
But, these beneficiaries (with some qualifications) qualify for “life expectancy” IRA payments: (1) the IRA owner’s surviving spouse; (2) her minor child; (3) disabled beneficiaries; (4) chronically ill individuals; and (5) individuals who aren’t more than 10 years younger than the deceased IRA owner.19
Working around the 10-year stretch IRA limitations using CRTs:
Taxwell Smart provides that on his death, a charitable remainder unitrust (CRUT), meeting all the CRUT requirements (for example, payout of at least 5%, maximum 50%, 10% minimum charitable remainder interest),20 pays his grandchild for life or term of years (not exceeding 20 years). This strategy will save estate taxes (because the estate will receive an estate tax charitable deduction for the value of charitable remainder interest) for Taxwell if he’s subject to that tax.
Whether Taxwell is or isn’t subject to the estate tax, the transfer of his IRA at his death to fund the CRUT won’t subject the heir to tax on income in respect of a decedent (IRD). Payments to the grandchild will be taxable under the four-category taxation regime. And, a charitable gift is made at the trust term’s end.
Keep in mind that the stretch CRT has to pass the 10% minimum remainder interest requirement.21 For younger heirs, the stretch can’t be for life but will be for a term of years (not exceeding 20 years). And, charitable remainder annuity trusts (CRATs) must also pass the 5% probability test of Revenue Ruling 77-374.
No surprise, charitable intent is important. The cost of generosity is reduced by the tax savings to the heir who can have IRA payments stretched more than 10 years.
Giving an heir an income tax charitable deduction:
Suppose Taxwell’s grandson is a successful farmer growing hedge funds in Greenwich, Conn. Grandson Hedgely is already rich beyond the wildest dreams of avarice. Nevertheless, Taxwell creates a testamentary CRUT with his IRA for Hedgely. Several years go by, and Hedgely concludes he really doesn’t need the CRUT payments. So, he gives his remaining life interest to the named charitable remainder organization (or qualified PC that Hedgely has named if he’s been given that power). Hedgely will then get an income tax charitable deduction for the then-value of his life interest. Taxwell has, in effect, given Hedgely an income tax charitable deduction. Hedgely on his own figured out how to benefit a charity during the term of his CRUT life interest and got an income tax charitable deduction.
Suppose Taxwell’s estate is subject to the estate tax. Taxwell tells Hedgely that he’s creating a testamentary CRUT for him funded with Taxwell’s IRA. Taxwell extracts Hedgely’s promise that he’ll give his remaining life interest to the named publicly supported charitable remainder organization within two years of Taxwell’s death.
If IRS Agent Seigfried learns of this, he could well deny Taxwell’s estate an estate tax charitable deduction for the charitable remainder interest and collect IRD tax from Hedgely. Taxwell and Hedgely had better talk about this in a motel room with the water running.
Planning With Personal Residences
Now’s an especially good time for individuals considering giving their personal residences to charities at death to consider giving the residences to charities now, but retaining life enjoyment. They’ll get significant income tax savings now for property that goes to charity when they go to the great beyond.
Getting an income tax charitable deduction now is smart tax planning. Less than one-tenth of 1% of estates are currently subject to the federal estate tax.22 And, the super-wealthy who are still subject to the federal estate tax will also get estate tax savings.
These examples below, prepared by nationally known charitable and estate-planning lawyer Lawrence Katzenstein with his Tiger Tables software, show why now (because of historically low IRC Section 7520 interest rates) is an especially good time for charitably minded individuals to give remainder interests in personal residences while keeping lifetime enjoyment.23
The examples assume a 0.6%24 Section 7520 rate (the September 2020 rate is 0.4%, and that makes the tax savings even greater).
Example 1. Donor, age 70, gives a remainder interest in her personal residence valued at $1 million. It has a 45-year depreciable life. The value of the house is $500,000, and the value of the land is $500,000. Her income tax charitable contribution is $777,000.
Example 2. The value of the 70-year-old donor’s house is $100,000 (it’s a teardown), and the value of the land plus salvage value is $900,000. Her charitable contribution is $890,712. Larry points out “since the IRS equates use of the residence to an income stream, if the IRC §7520 rate declines to zero (not impossible) the remainder in the land would be 100 percent.”25
The donor gets income, gift and estate tax benefits by making a charitable gift of a personal residence even though the donor keeps the right to life enjoyment.
Term of life enjoyment. A life estate may be retained for one or more lives. Or, the donor’s right to stay in the property may be retained for a term of years. Always check state rules against perpetuities.
Realty only. The deduction isn’t allowed for future interests in furnishings or other tangible personal property.26 However, property that qualifies as a “fixture” under local law can be included in the value. The favorable ruling in Private Letter Ruling 8529014 (April 16, 1985) hinged on the air conditioning and heating system being considered “real property” under local law. Had the system been deemed “tangible personal property,” income and gift tax charitable deductions would have been denied. And, it wouldn’t qualify for the annual gift tax exclusion because it was a gift of a future interest.
Practice pointer. A donor should give the tangible personal property by will if she: (1) contributes a remainder interest in a personal residence during lifetime, (2) wants the charity to have the furniture or other tangible personal property, and (3) believes she’ll be subject to the federal estate tax. As always, take any state taxes into account.
What qualifies as a personal residence?
Any property used by a donor as her personal residence, though it needn’t be the principal residence.27
A vacation home.28
Stock owned by a donor as a tenant-stockholder in a cooperative housing corporation if the dwelling that she’s entitled to occupy as a stockholder is used as her personal residence.29
Making a personal residence a tax shelter as well as a weather shelter: The easy part is the purely mechanical computation using IRS tables and formulas. The difficult part is determining hard fact questions: (1) the FMV of the property—with the FMV allocated between the land and the structures; (2) the estimated useful life of the structure (the longer the estimated useful life, the larger the charitable deduction); and (3) the value of the structure at the end of its estimated useful life (the greater the value at the end of its estimated useful life, the larger the charitable deduction).
And of course, the amount deemed contributed isn’t necessarily the amount that’s deductible. As always, the various percentage ceilings for gifts to PCs and PFs, holding periods and carryover rules must be considered.
In addition, it’s crucial that the property be appraised by a “qualified appraiser.”30
Caution. In Rev. Rul. 77-305, the IRS disallowed the charitable deduction when a donor and the charity agreed that if the donor was unable to continue living in the house (due to illness or old age), the house would be sold and the proceeds divided pro rata between the parties.
Reminder to charities. Before accepting any land gift (whether outright, in trust, a remainder interest or for a gift annuity), determine the charity’s potential liability under environmental impact laws.
Old McDonald has a farm. He can have a remainder interest in his farm and qualify for income, gift and estate tax charitable deductions. A farm is any land used by a donor (or her tenant) for the production of crops, fruits or other agricultural products or for the sustenance of livestock.31 The term “livestock” includes cattle, hogs, horses, mules, donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys, pigeons and other poultry.32 A farm, under IRC Section E.I.E.I.O., includes the improvements thereon.33
We began this article by quoting Groucho Marx and end by quoting Sir William Osler’s closing words to a graduating medical school class: “I have a confession to make. Half of what we have taught you is in error, and furthermore we cannot tell you which half it is.”
Coming Up
In next month’s issue,we’ll tell you how clients can make tax-advantageous outright bequests to family members that can indirectly benefit charities—rather than testamentary gifts directly to the charities. Plus, we’ll discuss disclaimers, split-interest charitable trusts and charitable gift annuities. And, that will be the latest news from Lake Taxbegone.
Endnotes
1. For more information on substantiating charitable deductions, see Conrad Teitell, Heather J. Rhoades and Cara Howe Santoro, “Substantiating Charitable Deductions at the IRS,” Trusts & Estates (July 2017). A recent case provided that substantial compliance was enough. Emanouil v. Commissioner, 2020 T.C. Memo. 120 (Aug. 17, 2020).
2. Internal Revenue Code Section 170(b)(1)(H).
3. IRC Section 170(b)(1)(C)(ii) and Section 170(b)(1)(G)(ii).
4. Section 170(d)(1) and Treasury Regulations Section 1.170A-10.
5. For more details on the specific deductibility rules, see Conrad Teitell, Stefania L. Bartlett and Cara Howe Santoro, “Charitable Deductions for Gifts by Individuals, Partnerships and Corporations,” Trusts & Estates (October 2018).
6. Section 170(b)(1)(E)(iv)(I). To be a qualified farmer or rancher, the donor’s gross income from the trade or business of farming must be greater than 50% of his gross taxable income. Section 170(b)(1)(E)(v). In addition, the contribution must be subject to a restriction that the property remains available for production. Section 170(b)(1)(E)(iv)(II).
7. Section 170(b)(1)(G)(i) and Section 170(b)(1)(G)(ii).
8. For his remarks, see supra note 5.
9. The Coronavirus Aid, Relief and Economic Security (CARES) Act (Pub. L.116-136).
10. What’s the line? Adjusted gross income. That means cash gifts are deductible from gross income.
11. Supra note 9.
12. Unless, as the Joint Committee on Taxation’s Explanation of the CARES Act states, the charitable remainder trust remainder interest is paid in cash to an eligible charity during 2020. Supranote 9.
13. Ibid.
14. Supra note 9, at Section 2205(a)(2)(B).
15. These are private non-operating foundations that distribute 100% of their contributions to public charities not later than 31⁄2 months after the close of their taxable year.
16. Notice 2020-46, “Treatment of Amounts Paid to Section 170(c) Organizations under Employer Leave-Based Donation Programs to Aid Victims of the Coronavirus Disease (COVID-19) Pandemic.”
17. Setting Every Community Up for Retirement Enhancement Act (effective Jan. 1, 2020). The U.S. Bureau of Acronyms must have worked overtime and had to stretch to come up with this acronym.
19. IRC Section 401(a)(9)(E)(ii).
20. IRC Section 664(d).
21. Ibid.
22. According to Chuck Marr, senior director of Federal Tax Policy at the Center on Budget and Policy Priorities.
23. “Charitable Remainder Gifts of Personal Residence and Farms,” Taxwise Giving (June 2020), at p. 2.
24. See how varying interests rates affect the charitable remainder interest in both Example 1 and Example 2 in ibid.
25. Ibid.
26. Revenue Ruling 76-165.
27. Treas. Regs. Section 1.170A-7(b)(3).
28. Ibid.
29. Ibid.
30. Section 170(f)(11)(E).
31. Treas. Regs. Section 1.170A-7(b)(4).
32. Ibid.
33. Treas. Regs. Section 1.170A-7(b)(4); Rev. Rul. 78-303. See also Section E.I.E.I.O.