On April 15, high income taxpayers will confront the first tax returns they’ll file under new tax rates that took effect in 2013. They’ll experience the practical impact of higher rates on ordinary income, capital gains and dividends. They’ll also encounter a number of indirect tax increases, such as the 3.8 percent Medicare surtax on unearned income and phaseouts of various tax benefits based on their income level.
While taxpayers were forewarned of these changes and urged by their advisors to take steps to prepare for them, many procrastinated and failed to act. Faced with the harsh reality of writing larger checks for 2013 taxes, we can expect clients to be both angry and open to advice on ways to blunt the effect of higher taxes on their 2014 income.
There are many approaches that individuals can take to legitimately reduce the amount of tax they pay. Some steps are relatively simple, straightforward and fully within the intention of Congress, while others involve mind-numbingly complex stratagems of dubious validity that could welcome attention by auditors.
I’ll focus on number of practical steps that those who are philanthropically inclined can take to help reduce their tax bite through use of time-tested techniques that are based in longstanding tax benefits intended by Congress and deeply rooted in long-term public policy.
While it’s always been a good practice to use long-term capital assets that have increased in value to make charitable gifts, rather than cash, this practice makes even more sense in today’s environment.
As in the past, such gifts are deductible at fair market value rather than their cost. That’s because donors are giving not only what they invested in the asset, but also their unrealized profit. The law permits use of the full value of the asset to offset other taxable income, while the lack of a sale by a donor means that no capital gain is realized and subject to tax. Why? Because the donor never realized the personal benefit of the gain. The donee charity takes the donor’s basis, but as a tax-exempt entity, it pays no tax on a subsequent sale. Congress also intends this result, as the capital gain is being directed to charitable purposes.
So far so good. But consider that as recently as 2012, the maximum federal capital gains tax was 15 percent. In 2013, that rate increased to 20 percent—or did it? In reality, the effective rate on capital gains and dividends for the highest income taxpayers was increased in 2013 to 23.8 percent, the total of the 20 percent capital gains tax and the 3.8 percent Medicare surtax levied for the first time on capital gains, dividends and other unearned income.
For example, if an investor sold stock that initially cost $20,000, for $100,000 in 2012, the federal tax incurred on the $80,000 in capital gain would have been $12,000. If that stock is sold in 2014, the combination of capital gains tax and the Medicare surtax would be $19,052, a 59 percent tax increase.
Unfortunately, too many donors still write checks for $100,000 in this situation, not realizing that they should give the stock and use the cash for other purposes, perhaps to repurchase the same stock and enjoy a new, higher basis or use the cash to diversify their holdings without the burden of the $19,052 in capital gains taxes. Tax policy, in effect, allows donors to voluntarily redirect the capital gains tax to tax-exempt purposes of their choosing. The donor doesn’t personally enjoy the $19,052 in either case. In the case of the gift, however, the taxpayer is given a choice as to where those funds are expended in society. This isn’t a tax shelter; it’s intentional public policy that too many donors fail to understand or effectively implement.
It’s important to note that the only way to avoid the 3.8 percent Medicare tax is to give the property and avoid realization of the gain. Once capital gains or dividends are realized, there’s no way for a charitable deduction to offset those taxes. That’s because the 3.8 percent tax is on adjusted gross income (AGI) subject to certain modifications. As a result, charitable gifts and other itemized deductions don’t serve to offset it.
By giving the stock rather than selling it, donors also don’t swell their AGI and, in so doing, trigger reductions in their itemized deductions and don’t suffer other negative consequences that follow from increasing their AGI.
Another option to consider when making gifts of appreciated assets is to make the donation to a donor advised fund (DAF). In this case, an immediate deduction is allowed for the full value of the donated assets, while, as in the case of an outright gift to charity, the capital gains and Medicare tax aren’t paid when the DAF sponsor sells the property. The difference is that the donor can advise the funds to more than one charity following the sale or direct gifts over a period of time.
Gifts Over Time
Charitable lead trusts (CLTs) afford similar flexibility for those who wish to make a series of charitable gifts over time. While a CLT isn’t a tax-exempt entity, CLTs are exempt from paying the Medicare surtax when capital gains and dividends are realized by the lead trust. For donors who can afford to forego income and would like to transfer assets to heirs on a tax-favored basis, a non-grantor CLT now offers the additional benefit of allowing them to redirect the 3.8 percent Medicare tax for charitable purposes as part of the charitable gifts completed via this gift vehicle. This would be the case for distributed net income from the CLT, although the 3.8 percent Medicare tax would, in fact, apply to earnings of a grantor lead trust when the settlor of the trust reports income or the CLT has undistributed net income that’s subject to the tax.
The CLT can also offer income tax planning opportunities for donors who are subject to the 20 percent, 30 percent or 50 percent of AGI limitations on their charitable gifts. Not receiving income is the same as receiving it and having it be fully deductible. For donors who’ve reached or exceeded deductibility thresholds, funding a CLT as a vehicle for making charitable gifts over a period of time can be a wise choice, as there’s no limit on the amount that can be given to charity each year from a CLT.
For example, suppose a couple, both age 70 with an estate of $25 million, has AGI of $500,000 in addition to a sizeable amount of tax-exempt income. They’re allowed to deduct up to 30 percent of their AGI, or $150,000, in the form of appreciated assets each year. Their limitation for cash gifts would be 50 percent of their AGI, or $250,000. A gift of $500,000 in appreciated stock and $50,000 in cash gifts last year consumed most of their capability to deduct other charitable gifts for three years.
Suppose they fund a non-grantor charitable lead annuity trust (CLAT) using $5 million from a diversified investment portfolio. The trust provides that 7.5 percent of the initial trust value, or $375,000 per year will be directed for charitable purposes for the next 16 years. At the end of that time, the value of the trust will pass tax-free to their heirs without necessitating the use of any of their gift or estate exemption amount. Over the 16-year period that the CLAT is in existence, some $6 million will be directed for charitable purposes in lieu of payment of gift and estate taxes.
The use of the CLAT results in “de facto deductibility” of the $375,000 per year that could be precluded in whole or in part by the aforementioned AGI limits. Note that these funds also wouldn’t be subject to the Pease limitations on deductions or phaseouts of other tax benefits based on the size of their AGI because the income doesn’t flow through their reportable income.
If donors would like to maintain some input on the use of the funds flowing from the CLAT, they could direct that the funds be paid to a DAF or a private foundation (PF).
Is this an unintended tax shelter? Not at all. It’s simply a byproduct of tax policy that encourages individuals to forego their wealth during their lifetimes in favor of immediate charitable use with the eventual use of the assets enjoyed by heirs. This is done in a way that results in directing the earning power of the assets to charitable use for a period of time and eventually distributing it to heirs after temporarily “disinheriting” them and, in so doing, lessening the concentration of that wealth.
For some wealthy individuals, the CLT can serve as a practical alternative to a PF that allows donors to realize charitable objectives over time without permanently depriving heirs of their inheritance.
Those who would like to make charitable gifts in the future, while using various tax policy incentives designed to encourage those gifts, might want to consider charitable remainder unitrusts (CRUTs) or charitable remainder annuity trusts (CRATs).
These trusts are also among the time-tested, mainstream gift planning tools that have existed for hundreds of years and were officially sanctioned and given statutory approval as part of the Tax Reform Act of 1969 and the countless regulations issued thereunder.
Under the terms of a charitable remainder trust (CRT), a donor is entitled to an immediate income tax deduction in an amount that Treasury regulations determine to be the value of the charitable portion of the split-interest trust. Donors are allowed the deduction because they’re permanently parting with the remainder interest at the time they fund the trust, and tax policy recognizes that they should be allowed to use that amount to offset current income that would otherwise be taxable.
Because the CRT is a tax-exempt entity, it doesn’t pay capital gains tax on any gains realized in the trusts, making it possible for the entire value of appreciated property transferred to the trust to be used for charitable purposes at the trust’s termination. Even though the donor to the trust will never directly benefit from the increased value of the property transferred to the trust, tax law provides that payments to the income beneficiary are based on the entire value of the assets transferred to the trust.
As in the cases of other tax-exempt entities, the Medicare surtax isn’t owed by the trust at the time assets are sold. Under the tier structure of income reporting by CRTs, however, the income beneficiaries of the trust will report the capital gains and owe the Medicare tax on the unearned income at the time it’s distributed. Making a gift in the form of the CRT does, however, have the practical effect of stretching the payment of the capital gains and Medicare surtax over time.
Finally, for those donors who don’t anticipate their estates being subject to estate tax under the new exemption levels, funding a CRT during lifetime not only can yield additional income over time and redirect income tax dollars for charitable use, but also can result in immediate tax savings for amounts that might otherwise be devoted to charitable use from a non-taxable estate in which no credit for the gift would be realized via estate tax savings.
A Split Interest Income Split?
In an interesting variation on the theme of redirecting income to charity outside a donor’s income stream for purposes of the AGI limits and excise taxes, a donor may wish to establish a CRT and provide that a portion of the income each year be paid to a charitable recipient rather than to non-charitable beneficiaries. This results in partial realization of the benefits of having income flow directly to charity rather than through the donor’s taxable income stream.
For example, suppose a 75-year-old couple with total assets of $10 million funds a CRUT that pays 6 percent per year for the remainder of both of their lifetimes. The trust is funded with securities worth $1 million with a cost basis of $300,000 that yield very little income. The donors will enjoy a current income tax deduction of $430,000 for amounts that might otherwise be a bequest to charity from what’s anticipated to be a non-taxable estate—yielding no savings to their estates on account of the charitable disposition.
The trust sells the securities and diversifies the holdings without payment of as much as $140,000 in federal capital gains tax at the time of the sale. The 3.8 percent Medicare tax isn’t due on the $700,000 capital gain, resulting in an additional savings of nearly $27,000. The entire $1 million is thus available to provide the couple with income, rather than $833,000 that would remain after tax to invest were they to sell the stocks outside the trust environment.
The donors provide that one-third of the annual trust payments, $20,000 the first year, be paid to one of their charitable interests. This amount won’t be reported as income and won’t increase their AGI for purposes of taxation of Social Security income and other negative results of increased AGI. If they live normal life expectancies of a total of 16 years, about $320,000, depending on the performance of the trust assets, could be directed for charitable use completely outside their reportable income.
If the charity is spending 4 percent of its endowment on programs each year, the $20,000 payment from the CRT would represent the equivalent of having $500,000 in additional “endowment” for the remainder of the donors’ lifetime, followed by the receipt of a permanent endowment of $1 million or whatever other amount remains in the trust at the donor’s death.
The net results are to allow the couple to increase their income in retirement without incurring capital gains on a diversification, provide immediate tax relief in the form of their charitable income deduction, provide for future tax-free buildup of the trust assets and create a source to automatically fund a significant charitable gift each year outside their stream of income in a way that doesn’t trigger undesirable side effects of increasing their AGI.
This trust functions as a sort of hybrid of a CLT and a CRT. It provides a partial income stream to charity for a period of time but, unlike the case of a CLT, the assets in the trust are earmarked for eventual charitable use as well. We might dub this particular trust a “Lunitrust.”
The preceding discussion touches on just a few ways to use incentives enacted by Congress to encourage philanthropy. Higher tax rates and reductions of a number of other “tax expenditures” by Congress make it more important than ever for planners to be prepared to advise their clients regarding the best ways to make their charitable gifts using mainstream techniques.
Charitable gift planning has occasionally been pursued by planners in terms of taking maximum advantage of income tax incentives provided by Congress for philanthropic activity. In other cases, the goal has been to make charitable gifts while providing as much as possible for heirs at the death of a donor.
Given the recent changes in both income and estate and gift taxes, it’s important for those assisting clients in their philanthropic planning to rethink how careful integration of tax and estate planning can result in making the greatest amount possible available for both charitable and non-charitable beneficiaries.