Give to Charity, Save on Taxes
Charitable giving not only helps a good cause, but presents the oppurtunity for significant tax savings along the way
The Internal Revenue Code encourages making gifts to charity by allowing taxpayers to take a deduction of up to 50% from their "contribution base" (adjusted gross income calculated without the net operating loss carryback deduction) (I.R.C. § 170(b)(1)(A) and (G)). For many, the use of this deduction provides the dual benefit of not only being able to donate to one's charity of choice, but also, at the same time, receiving significant tax savings. The I.R.S. places some limitations on the forms in which gifts can be made as well as what constitutes an eligible charity or private foundation.
In addition, the rules differ to some extent for corporations and trusts. A person should be aware of the existence of these many rules. Some rules to take note of are that, (1) for individuals, only cash or property can be used to reach the full 50% limit, (2) in comparison, trusts and estates can make any form of contribution limitation and (3) likewise, if a charity is named the beneficiary of an Investment Retirement Account (IRA) it will not pay any taxes upon receipt of the charitable contribution following the donor's death.
The basic rule for individual taxpayers is that deductions of up to 50% may be made from one's "contribution base". I.R.C. § 170(b)(1)(G) defines contribution base as "adjusted gross income" (computed without regard to any net operating loss carryback to the taxable year under section 172). (As a note, adjusted gross income is gross income minus certain "above-the-line deductions" and net operating loss carrybacks are specific loss deductions which may be applied to earlier tax years). Of course, like most areas of tax law, this broad general rule has several limitations which are described further below. As a result, the only gifts that may be used to reach the full 50% limit are gifts of cash or property (taken at its basis) to public charities or private foundations defined under I.R.C. § 170(b)(1)(A). (Practically speaking, charities will usually inform donors of their tax deductibility status). If a taxpayer makes donations in excess of the 50% limitation, that excess amount may be carried over and deducted up to five years into the future (I.R.C. § 170(d)). For instance, assuming Mr. Smith has a yearly contribution base of $250,000, and for both years one and two he donates the entire $250,000. As a result he may deduct only $125,000 in those first two years but in the following years three and four is able to carryover the remaining $250,000, deducting $125,000 in each year.
One limitation on the deductibility of charitable donations is that any donation not falling under I.R.C. 170(b)(1)(A), that is, gifts "for the use of" charities or to certain private foundations, may only be deducted to the lesser of 30% of the contribution base or 50% of the contribution base divided by allowable I.R.C. § 170(b)(1)(A) donation deductions (I.R.C. § 170(b)(1)(B)). "For the use of" contrasts with "to" a charity in that gifts are not made outright to the charity, but instead the charity has an income interest in property (for example, property held in trust with income going to the charity). Like the 50% limit, donations in excess of this 30% limitation may also be carried forward for five years (I.R.C. § 170(b)(1)(B)). Assume that in year one, Mr. Smith, again having a contribution base of $250,000, donates $125,000 to charity, $100,000 of which is "for the use of" charities or to certain private foundations and $25,000 falling under the general I.R.C. § 170(b)(1)(A) rule. Being limited by I.R.C. § 170(b)(1)(A), Mr. Smith may only deduct $75,000 of the first $100,000 (30% of contribution base of $250,000) plus the remaining $25,000 which, added to the first $75,000 brings the deduction total to $100,000, still being below the 50% threshold.
Another major limitation on the deductibility of charitable donations is that "capital gain" property may be deducted only up to 30% of the contribution basis. Capital gain property is either (1) a capital asset that, if sold at fair market value, would result in long term taxable gain or (2) I.R.C. § 1231 property, that is, property used in a trade or business which is excluded for the general definition of a capital asset. When donating "capital gain" property, a deduction can be made at the fair market value of the property at the time of donation without having to recognize gain on the transaction. Because of this benefit, such donations are thus subject to the 30% limitation. Again, any excess amount may be carried forward for five years (I.R.C. 170(d)). In addition, a taxpayer may elect under I.R.C. § 170(b)(1)(C)(iii) to deduct capital gain property at its basis value instead of fair market value, and in doing so, is subject instead to the 50% limitation as opposed to the 30% limitation.
Other limitations, as well as sublimitations to those discussed exist. One should be aware of these other rules and limitations, which include, among other things, special rules for certain types of property such as contributions of shares in S corporations (I.R.C. § 170(e)(1)), cars, boats, planes (I.R.C. § 170(f)(12)), patents and different forms of intellectual property (I.R.C. § 170(m)).
So, what do all these rules, limitations and limitations to limitations mean to a taxpayer hoping to maximize the charitable contribution deduction? First, for most donors, these limitations will have no affect on their deductions as most people do not make such large percentage of contribution base donations in a single year. Also, even if donations exceed the limitations for one year, the five year carryover period will provide enough time to deduct excess amounts. If however, a person does want or need to make donations to charity beyond the limitation and carryover amounts, there are a few, but not many, approaches to take. One option would be to think about deferring a donation or portion of a donation to a subsequent year in order to extend the carryover period beyond five years. This approach may not meet its full potential however if the donor dies before all deductions are made or if the property significantly decreases in value over future years. Another option, concerning the donation of capital gain property when basis is high compared to current fair market value would be to take the I.R.C. § 170(b)(1)(C)(iii) election discussed above and deduct the donation at the property's basis subject to the 50% limitation. A third option, if the donor is married to a healthy spouse, is to transfer the property to the donor and spouse as joint owners and then make the donation. By doing so, the carryover benefit will not be lost if one of the spouses dies before the benefit is entirely used (one note is that, with joint gifts, the death of one of the two spouses reduces the remaining carryover by one half).
Having dealt with only deductions for individual taxpayers, it is worthwhile to touch on the rules governing the deductibility of gifts to charity by corporations and trusts. A corporation, under I.R.C. § 170(b)(2), is limited to deducting charitable contributions to an extent not in excess of 10% of its taxable income (income that is taxed). This rule is much more simplified than those that apply to individual taxpayers, as most of the rules concerning what is being donated and to whom do not apply. As with individuals, corporations are likewise allowed a five year carryover for any amounts that exceed the 10% limit. Special rules exist for donations of certain corporate inventory and property under I.R.C. § 170(e)(3). Also, these rules apply only to C corporations, as different/more detailed ruled exist for donations made by S corporations under I.R.C. § 1366.
Trusts and estates have the most freedom when it comes to charitable deductions, being governed under I.R.C. § 642(c) as opposed to I.R.C. § 170. I.R.C. § 642(c) allows deductions for charitable contributions made by a trust or estate to the extent of gross income without any limitation if the amount is paid for a charitable purpose as described under I.R.C. § 170(c) during the taxable year. Because deductions may be taken to the extent of which there is gross income, there is no reason for there to be a carryover of deductions. Going back to the example of Mr. Smith, if Mr. Smith instead had created the Mr. Smith Trust, the trust having a contribution base of $250,000 and donating that amount entirely to charity, with no limitations, the full $250,000 amount would be tax deductible immediately, a great tool for tax free gifting.
Individuals with traditional IRAs might want to consider naming a charity as the beneficiary of their account in order to avoid taxes. If a person, for instance, has one million dollars in an IRA and additional assets which place them above the estate tax exemption when they pass away, the IRA distribution will be subjected first to the estate tax and then the beneficiaries of the IRA will be subjected to income tax otherwise known as "income in respect of a decedent" on the remaining amount (I.R.C. § 691). This can result in a significant portion of the IRA being spent to pay taxes. Instead, however, if a charity is named as a beneficiary, no taxes will have to be paid upon the death of the donor and money will pass tax-free to the charity. In addition, other techniques concerning IRAs and charitable contributions exist, including the use of a Charitable Remainder Unitrust (CRUT) and a "Stretch IRA".
Finally, when making gifts to charities, donors should be aware of I.R.S. rules concerning the appraisal of property as well as the need to have sufficient evidence of acknowledgement of receipt of property by the charity. If ever audited, proper information and verification will be required in order to substantiate charitable deductions.
All in all, depending on an individual's desires and circumstances, charitable contributions are often an excellent way to simultaneously give to charity while avoiding taxes. A number of options exist, and an individual's given situation should be examined to determine the most advantageous planning techniques to apply.
*Please Note: This article is only a general overview and should not be used to replace actual examination of the Internal Revenue Code and Treasury Regulations.
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