On Jan. 1, 2013, Congress enacted the American Taxpayer Relief Act of 2012 (ATRA). While this legislation will have broad impact on the nation as a whole, it promises to impact philanthropy in a number of ways.
Charitable Deduction Remains Intact
Throughout 2012, Congress made a number of proposals to limit the amount or value of charitable deductions. Some suggested a cap on the amount of deductions that could be claimed, regardless of one’s tax bracket. That led to fears that mortgage interest and other relatively fixed deductions would crowd out charitable gifts and result in the effective elimination of the charitable deduction for many taxpayers.
The Obama administration and others proposed limiting the value of itemized deductions to the 28 percent tax bracket. This would result in those in higher tax brackets being partially subjected to tax on amounts given to charity, resulting in an increase in the amount of pre-tax income required to make charitable gifts. For example, a person in the 39.6 percent federal income tax bracket who wished to make a $100,000 charitable gift would see the amount of income required to make the gift rise to just over $113,000 when taking into account the deductibility limit.
Fortunately, the legislation as passed doesn’t directly limit the tax deductibility of charitable gifts. Speculation abounds, however, that this issue will resurface in the next round of fiscal negotiations, as some involved in the process have promised to broaden the tax base by limiting various deductions and credits.
Pease Amendment Returns
There was also speculation that the so-called Pease amendment, which expired in 2010, wouldn’t be reinstated in the Tax Code. That didn’t happen. Those who work with higher income donors should be aware of this provision and be prepared to advise those who may be affected by it.
Initially enacted in 1991, the Pease amendment was designed to partially limit deductions for higher income taxpayers. Under its terms, total itemized deductions were reduced by 3 percent of the amount that a taxpayer’s adjusted gross income (AGI) exceeded a threshold amount. Beginning in 2013, the Pease amendment again applies with a threshold amount of $300,000 for married taxpayers who file jointly ($275,000 for heads of household and $250,000 for single persons).
Some commentators have expressed concern regarding the possible negative impact of the return of this provision. Judging from the 18-year period the Pease amendment was previously in effect, these fears are, for the most part, unfounded.
This can best be illustrated via an example. Suppose a couple has an AGI of $500,000. Their itemized deductions include $30,000 in mortgage interest, $10,000 in state taxes and $10,000 in charitable gifts. The Pease amendment will require that their itemized deductions for 2013 be reduced by 3 percent of the amount their AGI exceeds $300,000. Thus, they must reduce their total itemized deductions by 3 percent of $200,000, or $6,000. If they’re in the 39.6 percent marginal tax bracket, this means their taxes are increased by $2,376, an amount equal to an additional one half of one percent of their AGI.
Note that, even if they had made no charitable gifts, the $6,000 reduction would still apply, reducing their fixed deductions. Even if their AGI were $1 million, the Pease reduction of 3 percent of $700,000, or $21,000, wouldn’t even serve to absorb all of their mortgage interest, much less their other deductions. As a result, because their charitable gifts are well outside the Pease “reduction zone,” there’s arguably no practical impact on the value of their charitable deduction.
A small number of taxpayers with very high incomes and no deductions other than charitable gifts could, however, see a negative impact from the reintroduction of the Pease amendment.
Charitable IRA Gifts Extended
In addition to the significant new limitations on the amount or value of charitable deductions, ATRA included the restoration of the individual retirement account charitable rollover provision that allows individuals over age 70½ to make charitable gifts directly from a traditional or Roth IRA.
In addition to the extension of IRA rollover gifts made in 2013 subject to the same dollar limit ($100,000), and other restrictions in place since 2006, Congress created a special provision for gifts made from IRAs during January 2013. IRA gifts to charity completed before the end of January 2013 were deemed for tax purposes to have been made in 2012. This means that it’s possible for those who acted in a timely manner to make IRA rollover gifts of up to $200,000 in 2013.
Another unexpected, but welcome, provision was the “January Do-Over” provision. Taxpayers who took a withdrawal (mandatory or otherwise) from their IRA during December 2012 could make a cash contribution of all or part of the amount of the withdrawal up to $100,000 before the end of January 2013 and treat the gift as if it had been a direct distribution to charity that qualified as an IRA rollover gift for 2012.
In addition, Congress made the IRA gift extension retroactive to Jan. 1, 2012 to give relief to those who made a distribution to charity while unaware the provision had expired. Note that, unlike cash withdrawals taken in December 2012, to qualify for the retroactive provision, the distribution must have otherwise been a qualified distribution for 2012 purposes.
Higher Tax Rates
One of the more divisive issues surrounding the fiscal cliff negotiations concerned maximum tax rates for higher income Americans. While the president campaigned on higher taxes for couples with taxable income of $250,000 or more ($225,000 for heads of household and $200,000 for individuals), the final bill raised those amounts to $450,000, $425,000 and $400,000 respectively. For individuals with taxable income greater than these threshold amounts, additional income will be taxed at the pre-2001 tax cut maximum rate of 39.6 percent.
In the case of capital gains and qualified dividend income, income tax rates increase from 15 percent to 20 percent at the same income threshold amounts that trigger the new 39.6 percent tax bracket. A Medicare contribution tax of 3.8 percent on capital gains, dividends, interest and other unearned income passed in 2010 health care legislation will also come into play in 2013 for those with AGI over $250,000 ($200,000 for singles and heads of household).
As noted earlier, those who are subject to higher tax rates will be pleased to learn that their charitable gifts will be deductible against the higher rates and not limited to 28 percent or 35 percent, as had been proposed.
The after-tax cost of a charitable gift is, in effect, the amount a person would have left if he didn’t make a gift. If an individual is subject to a marginal tax rate of 35 percent, absent a charitable gift, he would have 65 cents of each dollar remaining to spend, save or give to others.
In the 39.6 percent bracket, he would keep just over 60 cents of each dollar if no gift were made. Thus, some argue that higher tax rates result in a lower cost of giving. If state income taxes are also applicable, a charitable gift saves even more. But this illustration also makes it clear that gifts to charity aren’t simply a “write off,” in which no cost is involved and no donative intent is required.
Note that it’s not appropriate to add the Medicare contribution tax on top of ordinary income tax to determine the after-tax cost of a gift, as the Medicare tax is an excise tax that’s paid on affected income, and no deductions can be taken against that income. Charitable gifts don’t, therefore, serve to reduce the tax on that income.
Appreciated property gifts are more attractive. The new higher capital gains tax rate, combined with increased ordinary income tax rates, means that gifts of appreciated stock and other qualified properties will be relatively more attractive than they were in the past. For securities and other appreciated property donated to charity in 2012, the combined tax savings of 35 percent for income tax and 15 percent for capital gains could result in a total savings of up to 50 percent, compared to 35 percent for cash gifts.
In 2013, on the other hand, with ordinary tax rates as high as 39.6 percent and capital gains tax rates increased to a maximum of 20 percent, the total savings can be just under 60 percent, a reduction in cost of as much as 20 percent for gifts of appreciated property, as compared to an 8 percent reduction in the cost of cash gifts.
In addition, for those subject to the 3.8 percent Medicare contribution tax, a gift of appreciated property will permanently bypass that tax, as well as the capital gains tax, because no sale takes place that would cause gain to be reportable. For that reason, the effective tax on capital gain income at the federal level could be as high as 23.8 percent, and the total tax savings from a gift could be more than 63 percent.
It’s also interesting to note that a gift of appreciated property not only results in the capital appreciation bypassing tax, but also keeps the gain from the property, were it to be sold, from swelling a taxpayer’s AGI and causing a greater reduction of itemized deductions under the Pease amendment, as well as additional phaseouts, such as personal exemptions that are also triggered by increased AGI.
As in the case of cash gifts, state capital gains tax could further increase the savings from appreciated property gifts, rather than cash.
With investment values in many cases recovered from recession declines and interest rates at record low levels, more philanthropically inclined individuals are choosing to make larger gifts in the form of charitable gift annuities, charitable remainder trusts (CRTs) and other split-interest vehicles. Higher income and capital gains tax rates and the Medicare contribution tax under ATRA will make the tax savings available from these plans even more attractive.
In addition, those advising clients considering such gifts should keep in mind that capital gains and qualified dividend rates remain significantly lower than taxes on other sources of income, even when taking the Medicare contribution tax into account. For that reason, gift vehicles that result in payments that are partially in the form of capital gains or qualified dividends will remain attractive when funded with appropriate appreciated assets to donors who are interested in a predictable source of tax-favored income.
AMT Permanently Patched
For years, Congress has periodically patched provisions of the alternative minimum tax (AMT), which would otherwise serve to ensnare millions of middle-income taxpayers for whom the AMT was never intended to apply. Congress acted to permanently raise the income level at which the AMT begins to apply and indexed that level for future inflation.
Some higher income taxpayers will continue to be affected by the AMT. They should be reminded, however, that charitable gifts have always been deductible against both the regular tax and the AMT. (An ATM gives you money, the AMT takes it!) The difference is that the AMT rate is lower and the tax savings are, thus, somewhat less. In no case, however, does a taxpayer subject to the AMT pay tax on amounts given to charity, as would be the case if the charitable deduction were eliminated or its value limited, as some have proposed.
Estate and Gift Tax Changes
Under other provisions of ATRA, Congress surprised observers by maintaining the exemption for both estate and gift tax purposes at $5 million, indexed for inflation ($5.25 million for 2013), and raised the maximum rate to just 40 percent.
Those who are working with clients with substantial estates should continue to emphasize the use of charitable lead trusts and other planning vehicles that can help charitably minded individuals make gifts while minimizing estate and gift taxes. When working with those who are no longer subject to estate taxes, many will find they now will have more discretionary estate dollars available, as they no longer must pay tax on amounts left to non-charitable recipients.
In other cases, older donors who may have planned for charitable bequests as part of their estate distributions and can now expect no estate tax savings may wish to accelerate the bequest and make it in the form of a CRT or other split-interest gift that provides them with immediate income tax savings, while also increasing their spendable income in times of lower interest and other investment returns.
In addition to making more broadly applicable changes, the new law includes a number of miscellaneous provisions.
Special rules for real property contributed for conservation easements are extended, as is the enhanced charitable deduction for contributions of food inventory and the basis adjustment to stock of S corporations making charitable contributions of property.
The law also reinstates phase-outs of personal exemptions for higher income taxpayers. This should have little impact on charitable giving, except to the extent that the loss of personal exemptions results in somewhat less discretionary income from which to make gifts. The same can be said for the end of reduced payroll tax deductions, which, for the past two years, have resulted in additional discretionary income for millions of donors. The loss of that benefit could also impact smaller charitable gifts by some donors.
When announcing the terms of the new tax law, commentators on both sides of the aisle made it clear that changes to the tax rates were just the beginning of a broader approach to deficit reduction. The president and others have mentioned the need to broaden the tax base by limiting deductions that “are not available to all Americans.” Reducing deductions has been termed by others as a reduction in tax expenditures. Whatever the case may be, further changes in the amount of deductions available, or their value, could be in the offing.
Early 2013 could be an excellent time for some to consider additional gifts that will almost certainly be fully deductible for 2013, if not in future years, after the next round of changes.
While almost every taxpayer will be affected by at least one of the provisions of the new legislation, those who enjoy supporting charitable interests will be relieved to find that a variety of proposed changes that could have negatively affected charitable giving weren’t included in ATRA. Also, valuable incentives remain in the Tax Code that serve to either lower the cost of charitable gifts or raise the amount it’s possible to give.