In 2010, Warren Buffett and Bill and Melinda Gates made news with The Giving Pledge, an effort to encourage the very wealthy to commit a minimum of 50 percent of their wealth to charity. The challenge has certainly resonated with the ultra-wealthy; over 80 of America’s richest families have publicly made the pledge. The effort has also created a conversation among many affluent families and their advisors about the desirability of such a plan, the assets required for such a pledge to be realistic and how to implement so bold an initiative. We find that first generation wealth creators are often quite conservative in the amounts of wealth they want their children to inherit—for fear that too much dampens the entrepreneurial spirit that has provided so much excitement for the first generation. Also, many express gratitude and some humility about their success, which seem to create a tie to philanthropy. These notions arise not just in the hearts and minds of billionaires, but also for those families with just $10 million, $20 million or $30 million in net worth. For this bracket of wealth, the “how” and “when” of making such significant gifts are critical to the preservation of a family’s financial security and the maximization of tax and other benefits. 

We’ll explore the steps, charitable giving vehicles, timing opportunities and potential pitfalls in making such a large lifelong charitable commitment. We’ll also examine the interplay of these considerations with a gift and estate tax system in flux, as charitably inclined families design and maintain an aggressive, but prudent, philanthropic strategy.   


Long-term Plan

A well-executed strategy requires a lifetime of planning, combined with steady and opportunistic charitable giving (this isn’t a full employment ploy for planners and estate lawyers, but, rather, recognition that the margin of error for the merely affluent philanthropist is much different than for, say, Bill Gates). The result is that the right amount of money gets to the right charities at the right times; the donor has the right level of balance sheet security at each stage of life; the children get the right amount of wealth; and income and estate/gift taxes are optimized. Two categories of variables affect the success of the plan. Controllable variables relate to the choices of charities themselves, the timing of gifts, the amounts and the structures used and the spending level of the family over time. The uncontrollable variables are numerous—changes in the tax law, investment returns, life changes among the family members, changes in interests and many more. A good long-term, dynamic plan takes into account the possibility of unforeseeable outcomes. Therefore, implementation is incremental (which is sometimes a challenge, as clients prefer the idea of this work being finished) and optionality is maintained wherever possible.


Key Decisions

The strategy begins with an analysis of a few key decisions. There are no right answers, as each family will be different, but after an initial plan is developed, the wise family will regularly revisit its objectives, financial situation and the macro environment to keep the plan finely tuned decade after decade. 


1. Determine the size of the security blanket of wealth that must be maintained for peace of mind. For most families, taking care of the nest egg, the source of support for one’s lifestyle, should be the highest priority. The size of the required nest egg, however, will depend upon investment return and consumer price index (CPI) expectations. Over the last five to 10 years, most investment experts have revised downward long-term return expectations, which increases the size of the needed reserve. The return on the reserve needs to provide for lifestyle spending, as well as income taxes and some capital that’s retained to preserve purchasing power. Conservatism is important so that unforeseen circumstances don’t put the family’s well-being at risk. 


2. Determine how much to leave heirs. Entrepreneurs and other first generation wealthy individuals frequently start with a low number of what they wish to leave their children, when the liquid wealth is new and the children are young. In this situation, estate planning in the early stages accomplishes two things: (1) it creates an emergency plan for the remote possibility that something happens to the mother and father, and (2) it serves as the first step in a commitment to what the children will get and what charity will get at the end of the parents’ lives. As the children mature, grandchildren arrive and the family gets more comfortable with their level of wealth, wills and revocable trusts can be easily adjusted. 


3. Calculate a reasonable amount that can be given away in a typical year, after the spending rate and security blanket size are determined. Several variables influence the appropriate amount to give away in a given year, and they’re highly individualistic for different families. For most, there’s no rule book that tells you the right amount to give. For some, tithing is a lesson learned early in life that will always drive a family’s level of charitable giving on an annual basis. (For entrepreneurs who sell a business, the sales proceeds may or may not be considered income for purposes of the tithing calculation.) For many others, the level of annual giving is often a default, derived from a history of the usual amounts to the usual charities, with increases that result from a larger asset/income base and new charities added periodically. 


Strategic Approach

We recommend a more strategic approach: Evaluate the sources of income and growth (for example, size of the investment portfolio and expected return, income from salaries and other sources) and assess the demands on them (for example, lifestyle spending, CPI protection and taxes), then see what’s available for charity. For a family that no longer has a paycheck and lives on the portfolio, an expected return of 7 percent might be allocated as follows: 3 percent for CPI protection that needs to be reinvested and 1 percent for income taxes, leaving 3 percent for lifestyle spending and charity. A comparison of the amount derived from this analysis to what’s actually being spent and given away often yields interesting lessons and conversations. As a couple ages, the nest egg doesn’t need to be as large, spending usually decreases and charitable giving can grow as a percentage of net worth, resulting in a decrease in principal. However, this decrease must be carefully managed, to take into account the risks provided by the uncontrollable variables discussed previously.


Gifting 50 Percent

If the spending rate and asset base allow, consider maximizing annual contributions by gifting 50 percent of adjusted gross income (AGI) each year. For passionate donors with larger asset bases, significant benefits accrue by giving 50 percent of one’s AGI each year to charity. We often find families whose annual giving patterns aren’t reaching capacity, although they plan on making significant gifts to charity in the future or at death. Sometimes, this is a result of a donor not fully developing his areas of charitable interests. If the nest egg and spending analysis indicate that there are excess dollars available for heirs or charity in the long run, we point out that optimizing current giving preserves capital. 

Reducing the income tax liability year after year has a significant impact on enhancing the after-tax return of all the family’s activities. In addition, the dollars set aside for charity can accrue free of income tax, enhancing the long-term return of the strategy. Therefore, the family establishes a donor advised fund (DAF) or private foundation (PF) to allow for tax-free growth, as well as for the beneficial decoupling of the timing of the contribution that provides the deduction and when the actual donations are made to the charities. 

For someone who maximizes contributions at 50 percent and minimizes taxes over the long run, a blend of different types of contributions is advantageous. Gifts of appreciated assets to a charity are very attractive, because tax is never paid on the appreciation and the deduction is valued at the fair market value. These gifts are generally deductible at 20 or 30 percent of AGI. Eliminating capital gains taxes (currently at 15 percent and likely to increase) for asset contributions over a number of years can significantly enhance the tax efficiency of a portfolio. A donor can further maximize the benefits of this strategy with gifts of cash filling the bracket between the 20 or 30 percent gifts up to the
50 percent level. Therefore, one can use a blend of cash and appreciated property gifts to public charities, DAFs and PFs to maximize the utility of this strategy. 

This level of annual giving should never put at risk the spending reserve or planned inheritance discussed above, but doubling the tax benefit that comes with lifetime giving—an income tax as well as an estate/gift tax deduction—makes it a strategy worth considering. 


Positive Financial Events

Take advantage of positive financial events—extraordinary inflows of cash accompanied by increased taxable income—by setting aside more permanent dollars into a DAF or PF. Whether the taxpayer is a serial entrepreneur, the beneficiary of a significant inheritance, a lottery winner or a typical investor, balance sheet growth and income levels are rarely constant. Once a family has strategically defined an appropriate level of annual giving, as well as a long-term goal of committing capital to future philanthropy, extraordinary financial events can be tactically used to move the needle closer towards their goals. Good planning can reap large rewards in the case of an initial public offering of a closely held business or a sale to a private equity firm. 

The planning, which involves running detailed projections of various scenarios, allows for all the work outlined in the earlier steps to be revisited, to help the family determine what it wants to accomplish with a new set of facts. The infusion of capital allows the family to make a one-time commitment to the long-term philanthropic goal without having a negative effect on current spending and gifting. In addition, the higher tax bill that results from the business sale or other event is offset by the charitable deduction. Deferring the planning until after the taxable transaction can cause the income to fall in one year and the significant contribution to occur in the following year, when the deduction may not be fully used. In many cases, pairing the timing of an income recognition event and the charitable deduction reduces the likelihood that the taxpayer will be in alternative minimum tax, which would cause a capping of the tax benefit of the deduction at 28 percent. A two-year tax projection, looking at the year of the large AGI and the year following, indicates the best timing of the contribution, as well as the timing of the state income tax payment. 


Maximize Lifetime Exemption

Consider the efficient uses of charitable planning structures that maximize the benefits of the lifetime exemption amount and other income tax strategies. The best plans take shape over a lifetime, as change happens for better or worse—a person’s circumstances, family dynamics and children’s well-being, philanthropic passion, investment expectations, interest rates and tax laws, to mention a few. The choice of trust structures differs with objectives, asset types and interest rate environments. 

Charitable remainder trusts are attractive in higher interest rate environments when a client has a highly appreciated asset, a need for income for a term of years or a lifetime (for himself or a family member) and a charitable intent to fund a gift in the future. The effect of the trust is deferral of the tax on the diversification of the appreciated asset, an income stream that’s tax efficient to either the donor or a loved one and a legacy left to a beloved charity in the future. The designated charity can be a specific public charity or a DAF, the latter providing more flexibility for charitable beneficiaries to be identified closer to the time of termination. In the right circumstances, a charitable remainder trust addresses income needs, manages taxes and provides a significant charitable gift.

Charitable lead trusts are generally more tied to estate planning than remainder trusts. A lead trust provides distributions to charities during the term of the trust and pays out the remainder at termination, typically to the next generation. When interest rates are low, the value of the remainder interest (which determines the amount of lifetime exemption used) is also low and, therefore, this vehicle is highly tax efficient. In the current interest rate environment, a lead trust of 20 years with a
5 percent payout has a gift value of close to zero. Lead trusts aren’t tax-exempt, like charitable remainder trusts, so there’s no benefit to funding a lead trust with appreciated assets. Charitable lead trusts can either be grantor or non-grantor trusts.

With a grantor trust, a charitable deduction is available to the donor in the year of funding, valued at the present value of the deemed distribution stream. This might be particularly attractive if the trust is being funded with proceeds of a liquidity event that’s creating an infusion of capital as well as taxable income. The income of the trust is taxable to the grantor each year. The payment of tax by the grantor can also be seen as an additional gift to the remainderman, as it better maintains the principal of the trust, but we find many donors reluctant to maintain responsibility for the on-going tax liability, in spite of the savings.

In the case of a non-grantor trust, no charitable deduction is available to the donor in the year of funding. The trust is a separate taxpayer, each year paying its own tax on income and gains, less trust expenses and the charitable deduction for that year’s distribution. Interestingly, these trusts can be extremely tax efficient. The charitable deduction and other expenses, which might be 5 or 6 percent of the original trust principal, as defined in the trust document, are likely to exceed taxable income, creating a taxable loss. This loss isn’t allowed to be carried forward or back and has little value. With some year-end planning, appreciated assets can be sold so that the realized gain is enough to offset the anticipated net loss. Because the sale is a realized gain, not a loss, the wash sale rules don’t apply, and the assets can be repurchased immediately, getting a stepped-up basis. Over time, this strategy provides great income tax efficiency to a strategy that’s already estate/gift tax efficient. 


Don’t Delay

While the most conservative planners might recommend delaying major charitable giving until an ultimate bequest, we encourage our clients to enjoy the pleasure of making charitable gifts over the course of their lifetimes. For families who desire to make a significant charitable impact, a dynamic and life-long strategic plan integrates a family’s charitable initiatives with effective income and estate tax management. If tax rates increase, the benefits accruing from the tax-efficient coordination of philanthropy and investments will grow significantly. You don’t have to be a billionaire for a 50 percent charitable pledge to make sense. It can be accomplished with incremental steps that bring joy and satisfaction, while protecting against the possibility of regret. A lifetime of giving binds a family together in the act of generosity and creates a classroom of effective and satisfying contributions from which all family members can benefit.