As we look back on 2012 from a philanthropic perspective, the one word that comes to mind is “uncertainty.”
As the economy has gradually recovered from the damage inflicted by the recession of 2007 to 2009, charitable giving has followed that trend. But, despite improvement, amounts donated in 2011 were still far below the 2007 peaks. Leading industry experts have predicted it could be as late as 2022 before giving completely recovers.
Even as the economy gradually recuperates, continued fluctuations in asset values and uncertainty about the future of federal tax policy as it regards charitable giving continue to weigh on the minds of clients contemplating gifts—especially gifts of larger sums. As we go to press, lawmakers have not acted on the looming “fiscal cliff,” though a number of proposals have been made that would affect charitable giving.
Fortunately, information has come to light from the Internal Revenue Service and other sources that illuminates the impact of the economy on charitable giving in times of economic turbulence and how donors are making their gifts in light of the current and proposed tax picture.
Not surprisingly, the IRS data indicates that the majority of the decline in tax deductible outright gifts was during 2007-2009. The IRS traced the bulk of the decline to individuals with incomes over $200,000, who dropped their giving by 34 percent, as compared to just 4 percent by those with lower income levels. The bulk of the drop in giving was also related to asset values, as gifts of non-cash assets dropped by 46 percent, compared to a 9 percent drop in cash gifts. As giving has begun its recovery, those with incomes over $200,000 making gifts of securities, real property and other non-cash assets have led the way. Individuals who earn $200,000 or under have only modestly increased their cash gifts.
According to an IRS report on split-interest trusts for 2010, trends reported in 2009 continue. The IRS notes that of the various types of split-interest trusts, charitable lead trusts (CLTs) continued to be the most commonly created gift vehicle in 2010. Lower interest rates and concerns about the gift and estate tax exemptions continue to drive the popularity of CLTs.
Other interesting findings in the IRS report were the average lifespans of various types of trusts that terminated in 2010. Surprisingly, CLTs existed for the shortest period of time, just 12 years. Charitable remainder trusts (CRTs), on the other hand, lasted for an average of 14 years in the case of unitrusts and 16 years for annuity trusts. These figures indicate that individuals who create CRTs may be older at the time they fund their gifts than much of the literature in the field might suggest. The time periods indicate either relatively short term-of-years trusts or trusts based on life expectancies of individuals in their mid-70s or older.
Also of interest in the IRS study was the fact that, as in the past, some 65 percent of CLTs report assets with a book value of less than $1 million. Of this group of 4,300 trusts, the average asset value was $324,000. There are nearly 300 trusts in existence that hold an average of $40 million in assets. While these are the ones that tend to attract the most attention, practitioners should keep in mind that the CLT can be a very effective tool for those of relatively modest means who would like to fund charitable gifts over a period of time, while assuring an inheritance for heirs at an appropriate time in their lives.
Bank of America Study
Another recently released report, The 2012 Bank of America Study of High Net Worth Philanthropy (Bank of America Study),1 is also helpful in considering how the wealthy approach philanthropy in today’s complex environment. Researchers asked wealthy philanthropists how certain proposed and scheduled changes to tax laws may impact their charitable giving. The results indicate that changes to income and estate tax laws could significantly affect the amount donors give during lifetime and at death.
When asked whether elimination of the charitable deduction for current gifts would affect the amount they give, 49.9 percent said their giving would remain the same. On the other hand, 48.5 percent said they would decrease their giving under those circumstances. Of those, 20 percent said their giving would dramatically decrease.
Effect of Requiring After-Tax Giving
While some have predicted that an elimination of the charitable deduction would have a negligible effect on charitable giving, the Bank of America Study indicates that about half of higher income donors would reduce their charitable giving if they were suddenly required to make gifts from after-tax, rather than pre-tax, income.
A donor who made a deductible gift of $10,000 under current tax law would need $10,000 worth of income to make the gift. With no charitable deduction, donors in the 35 percent bracket would instead need income of $15,385 to make the same $10,000 gift after paying $5,385 in tax. The elimination of the charitable income tax deduction for gifts would, thus, result in a 54 percent increase in the amount of pre-tax income required to make the gift!
When considered from this perspective, it’s not difficult to understand why an affluent donor might reduce the amount he gives to charity. To keep the amount of income earmarked for charitable gifts the same, the donor would have to give less. He would need to reduce the size of the gift from $10,000 to $6,500, the amount that would be left after paying $3,500 in taxes on the pre-tax income.
Impact of Income Tax Increases
As of this writing in December 2012, we don’t know if there will be an income tax increase. If income tax increases do take place as scheduled—with or without limits on the deductibility of gifts—one could argue that charitable giving will be negatively impacted as taxpayers spend, save or give away less discretionary after-tax income. If, on top of higher tax rates, the charitable income tax deduction is also limited or eliminated, a more serious impact might well be expected, as discretionary dollars are reduced at the same time donors are required to make charitable gifts from either fully or partially taxed income.
In light of this analysis, those involved in the process of seeking voluntary expenditures for charitable purposes should closely follow Congressional debates about if and/or how much deductions for charitable gifts should be reduced. The stakes could be much higher than many seem to realize.
According to Giving USA, individuals gave $216 billion to charity in 2010. The IRS reported that those who itemize gave $170 billion of that amount or 79 percent of the amount donated by living individuals. It’s easy to understand—given the math illustrated previously—why nearly half of high-net-worth individuals say they would reduce their gifts if they suddenly had to make them from after-tax dollars.
Estate and Gift Tax Changes
The Bank of America Study also sheds light on what can be expected from changes in estate and gift tax policy. Over the past decade, these tax rates have fallen, and the amounts subject to tax have been decreased. And there continue to be calls for complete elimination of the federal “death tax.”
The estate tax is now scheduled to increase dramatically in January of this year, unless Congress previously acts to prevent this. That means the $1 million tax threshold and 55 percent maximum rate under 2001 law will return as part of the expiration of the Bush-era tax cuts.
In light of what will undoubtedly be a vociferous debate over the future of the federal estate tax, the response to another of the questions in the Bank of America Study is of interest.
When asked what effect elimination of the federal estate tax would have on their plans to make gifts from their estates, only 5 percent of respondents said that it would cause them to reduce these gifts. Just under 58 percent said their plans would remain the same, while 37 percent said they would increase the amount they would leave to charity from their estates. These findings seem to contradict traditional wisdom that an elimination of estate taxes would lead to reduced giving at death. What are these respondents thinking?
Suppose, for simplicity’s sake, a donor has an estate of $10 million and a 50 percent estate tax would apply to amounts not left for charitable purposes. As there have been no serious proposals to reduce or eliminate the estate tax charitable deduction, we’ll assume those amounts would remain deductible from the otherwise taxable estate. If the owner of the $10 million estate left $1 million to charity and the remainder to family, the charity would receive $1 million and the family would receive $4.5 million after payment of 50 percent tax on the $9 million taxable estate.
Assume now that the estate tax is repealed. The charity would receive $1 million and the family $9 million. Why would a rational person who had previously decided to include gifts for charitable purposes as part of his estate reduce or eliminate those gifts under those circumstances? In fact, in that situation, the charitable bequest could actually be doubled to $2 million, and the family would receive $8 million, nearly twice the $4.5 million they would have received if their portion had been taxable!
While it’s anyone’s guess what direction lawmakers will take on policies affecting charitable giving in the future, it’s clear from surveys of the wealthy that while taxes aren’t the primary motivation for making charitable gifts, they’re inextricably linked to the amount and timing of those gifts.
If, as some have proposed, both the charitable income tax deduction and the estate tax were to be eliminated, the Bank of America Study indicates we can expect a decrease in lifetime giving by the wealthy, with an increase in gifts directed from their estates at death.
If the charitable income tax deduction is retained and estate taxes are kept at their relatively low current levels, we can expect little impact on current giving, while somewhat greater assets may be expected to be directed for charitable purposes at death than during times of higher estate taxes.
Tax rates and deductions during lifetime and at death, apparently, do matter and may matter more than some believe. It appears that 2013 could be a year featuring much debate on the relationship between tax policy and philanthropy. When advising clients, the place to start, as always, is with the real motivations underlying a client’s philanthropic goals. Then, build from there using the best tools that remain under the tax laws at the time to maximize the total benefit to both the client and the charitable interests involved.