American society has long been defined by an intricate and unique combination of the roles of government, business and the non-profit sector. Other cultures exist with most, if not all, of their society's needs met by business and government sectors that divide responsibility for funding religion, healthcare, education, welfare and other social needs. The role of the non-profit sector is minimal, if it exists at all. The Soviet Union, in its prime, springs to mind as a system in which the government attempted to meet all of society's needs.

When our founding fathers decreed that there be a separation of church and state, they assured a permanent role for the non-profit sector in this country. What they didn't do, however, was provide for how it would be funded. America's citizens responded by developing a somewhat unique system of voluntary action and financial support designed to meet many of society's needs. Over time, this solution has become intertwined with our nation's tax policies.

In the midst of the debate over tax rates and deductions, the relationship between the government and philanthropy and how the non-profit sector should be funded has once again surfaced. This is an area where those on both ends of the political spectrum find similar directions from their ideological compasses.

Opponents Advocate Limit

On one hand, conservatives advocate minimal government involvement in social issues and believe that private enterprise and philanthropy should meet those needs. They deride the charitable deduction and direct government grants to nonprofits as unnecessary meddling in society that ultimately results in higher tax rates.

For example, as part of the Reagan administration's efforts to enact a flat tax in 1984, the Treasury proposed limiting the charitable deduction to amounts donated in excess of 2 percent of adjusted gross income and limiting deductions of appreciated assets to a donor's cost basis as adjusted for inflation.

Because Americans historically give approximately 2 percent of their incomes to charity, this proposal would have been tantamount to limiting deductions for charitable gifts to those who give above-average amounts and can afford to limit their deductions to gifts of cash.

A similar 2 percent limit proposal has recently resurfaced in one of the study commission reports recommending means to achieve deficit reduction. This would be coupled with a 25 percent tax credit for gifts above the 2 percent floor.

Some in the liberal camp ironically endorse similar approaches. At the extreme, they advocate increased taxes on those considered to be “rich” and greater spending on social programs directed by professional civil servants who presumably know best how to solve the problems that are depriving many of our citizens of the “good life.”

Some among this group see charitable deductions as a way that government subsidizes the philanthropic whims of the wealthy by foregoing revenue that could be better spent by government. The Obama administration has put forth budget proposals to limit the benefits of the charitable deductions for higher income donors to the 28 percent rate and impose tax on donated funds at a rate represented by the difference between 28 percent and the highest marginal rate. These proposals spring from this school of thought.

Possibility of Ultimate Survival

How will this play out? Will the charitable income tax deduction ultimately survive? Will it be converted to a credit? The outcome is anyone's guess. Recalling a lecture from my law school days, however, it seems likely that the charitable deduction will survive as long as there are any deductions at all.

The charitable deduction was one of the first deductions when it was introduced in 1917 and will perhaps be among the last to go. My tax law professor pointed out there are opponents of the charitable deduction at both ends of the political spectrum, but there are also strong supporters who occupy the broad middle ground. Those who are on the liberal side believe it's a good idea for government to pick up part of the cost of charitable gifts to meet needs it doesn't fund, while those leaning more to the right believe it's not fair to exact a tax on funds that are voluntarily foregone for charitable use.

Perhaps the best argument for the continuation of the charitable deduction is based on the concept that income that's given to charity has more in common with adjustments to gross income such as alimony, than with the mortgage interest deductions.

In the case of the tax deduction for mortgage interest, the government is intentionally incentivizing the ownership of homes. From the conservative perspective, this represents social engineering. In the case of alimony, on the other hand, the government isn't encouraging divorce. The exclusion of alimony from income for tax purposes is based on the recognition that it isn't properly considered the taxpayer's “income.” It's income that will be spent by another person and that person should pay the tax on the right to receive and spend those funds. In a sense, charitable gifts represent the voluntary redistribution of income and an argument can be made that the proper course of action is to exclude those amounts from the definition of “income” and hence from tax.

As for the argument that the rich save more through deductions than others, that's only the case because they pay more taxes and will have less to give if they are required to pay tax on amounts donated to charity. If the charitable income tax deduction were eliminated, the cost of making charitable gifts would rise for all who itemize deductions. Persons in the highest tax rates would feel the change the most.

For example, suppose George is in the 35 percent tax bracket. If he gives a gift to charity of $10,000 that's fully deductible, he saves $3,500 in taxes and the after-tax “cost” of his gift is $6,500. That's the amount he would have remaining after tax to spend or save if he hadn't made the gift. If the charitable deduction is eliminated and George gave $10,000 to charity, he would pay out-of-pocket the $10,000 he gave, plus he would owe an additional $3,500 in tax on the donated funds. It would then require $13,500 to make the same gift he could make for an outlay of $10,000 if it were deductible.

If he wanted to keep his out-of-pocket cost the same, he would be advised to reduce his gift by 26 percent to just over $7,400. He would hold back the $2,600 necessary to pay the tax on the amount given, making his total outlay $10,000 as it was before. The argument boils down to the fact that people will give less when the cost of giving rises substantially, and the services not funded by their voluntary giving will then be curtailed, falling on the government (and higher taxes) to provide the services if they are to exist at all.

Creative Solutions

The coming months promise to be interesting ones for those who advise clients on their estate and financial planning. The tax legislation enacted in 2010 left charitable incentives largely unchanged and the underlying debate will grind on. At the same time, the U.S. population continues to age rapidly. The first of some 78 million baby boomers will reach the age of 65 in 2011. The United States' nonprofits will be watching its traditional donor base age at the same time that tax incentives for giving may be curtailed to a greater or lesser extent.

History tells us, however, that people will turn to ways to give that help them meet their needs and those of their families while still making charitable gifts. In the words of Samuel Johnson in the 1770s when asked to comment on a gentleman who had left his fortune to a college at Oxford, “Whether to leave one's whole fortune to a College be right must depend on the circumstances. I would leave the interest on the fortune I bequeath to a college to my relations or my friends for their lives. It is the same thing to a College, which is a permanent society, whether it gets the money now or twenty years hence: and I would wish to make my relations or friends feel the benefit of it.”1

Fortunately over the years, many tools such as the arrangement alluded to by Johnson, have been developed that rely on trusts and other mechanisms to help charitably inclined individuals achieve multiple objectives. As the donor population in the United States ages and the overlap between philanthropy and financial planning naturally grows, the role of those who advise their clients on how best to meet their objectives, regardless of the vicissitudes of charitable tax laws, will only grow and the rewards for society as a result of their efforts will multiply.

Endnote

  1. James Boswell, The Life of Samuel Johnson (1993) at p. 648.

Robert F. Sharpe, Jr. is president of The Sharpe Group in Memphis, Tenn.

SPOT LIGHT

Soon It Will be Sundown

This French “Le Cauchemar De Dracula” (“Horror of Dracula”) movie poster (120 cm. by 160 cm.), sold at Christie's Vintage Film Posters auction in London on Dec. 1, 2010 for $4,668. In the film, Dracula can be destroyed by sunlight, whereas in the Bram Stoker novel the movie was based on, his powers are merely limited by daylight.