There are many types of charitable giving. But whether it’s dropping a dollar or two into the Christmas kettle, sending a check to a favorite charity or setting up a foundation, giving feels good. In fact, a 2006 study found that when people give to one or more charities, it activates regions of the brain associated with pleasure, social connection and trust, creating a “warm glow” effect.
Those who itemize deductions on their federal income taxes usually understand that charitable giving can be tax deductible. The bigger question is: How can a person of means do the most good while optimizing the tax benefits that accompany philanthropic giving?
Tax-deductible donations are those that go to tax-exempt charitable organizations, which are governed by section 501(c)(3) of the Internal Revenue Code. Hence, they are known as 501(c)(3)s – “c” signifying “charity” or “qualified charity.” An organization’s status can be verified with the IRS Exempt Organizations Select Check tool.
This article will look at the types of donations that count as charitable giving, with an eye toward their tax advantages. We also will consider the three main types of charitable organizations and some tax- and estate-planning vehicles for making charitable contributions.
A great many things can be done in the name of charity, but any good tax professional knows that the Internal Revenue code lays out definite rules about what qualifies as a charitable deduction. Let’s look at four types of donations, how they’re treated on a tax return and how they can be structured to optimize tax savings.
Charities love cash because it’s easy to assign value and can be put to immediate use. Plus, it’s the most straightforward way to donate. For taxpayers who don’t use itemized deductions, only a few hundred dollars’ worth of cash donations can be deducted.
Itemizing usually does make sense for higher-income individuals and families who have large deductions, such as state and local taxes and mortgage interest in addition to charitable donations. Under the CARES act, a taxpayer could deduct cash contributions equaling up to 100 percent of their adjusted gross income. However, that ship sailed in 2021. Unless Congress changes the tax law again, the limit on deductibility of cash donations is 60 percent of AGI.
If the donation exceeds 60 percent, it should still be reported because it can be carried over for five years.
Typically, the deduction equals the amount of the gift, less the value of any goods or services received. Checks and credit cards are the best way to make cash contributions because there’s a record. In any case, retain letters and receipts documenting cash contributions.
Let’s say someone wants to donate $100,000 to their local food bank. Should they sell stock and donate the proceeds, or donate the stock itself?
Depending on tax bracket and whether the stock in question is a long-term holding that has appreciated, donating stock could generate a greater tax benefit than selling it and making a cash contribution. The reason? Capital gains!
When an appreciated asset is sold, the owner is on the hook for 20 percent in long-term capital gains tax and 3.8 percent net investment income tax. There may also be state and local taxes. If the stock is given directly to a charity, though, the charitable deduction remains the same. Also, the donor avoids the capital gains tax. The brokerage must be informed that the stock is being transferred “in-kind.”
This type of income tax deduction is limited to 30 percent of AGI. Again, if the entire deduction can’t be taken in a given tax year, it can be carried over for up to five more years.
For stocks that have decreased in value, only the fair market value can be deducted. In this case, the donor might be better off selling the stock and taking the capital loss, then giving the proceeds to charity.
Before making such a decision, it’s a good idea to consult with a tax expert or investment advisor.
A great many rules apply to contributions of personal property. Generally, the amount of the contribution is the fair market value of the property being donated. If it’s $500 or more, there’s a special IRS form. Donations can’t exceed 30 percent of AGI but can be carried forward.
If donated tangible assets like vehicles, artwork and jewelry are valued at over $5,000, the IRS requires a written appraisal. If the charity sells the item, the sale price is the deduction.
Regular C Corporations can donate excess inventory in-kind to qualified nonprofits and receive very favorable tax treatment. Deductions are equal to the cost of the inventory donated, plus half the difference between the cost and selling price, not to exceed twice the cost.
Transferring the deed or title to a charity is the simplest way to donate real estate. The size of the deduction usually depends on whether the real estate is a short-term asset (held one year or less) or a long-term asset (held more than one year).
Short-term. The deduction is equal to the lesser of the property’s fair market value or its cost basis. This limitation applies to all donations to private foundations, even if the donated assets have been held long-term.
Long-term. The deduction is equal to the fair market value of the property. The deduction is generally limited to 30 percent of the donor’s AGI.
Though time is a valuable asset, the IRS doesn’t consider it to be deductible. However, expenses related to volunteering are deductible, such as mileage and tolls; required uniforms (like those required of volunteer paramedics); and, if involved in volunteer fund-raising for a 501(c)(3), the cost of wining and dining a prospective donor.
Qualified charities generally fall into one of three buckets: public charities, private foundations and private operating foundations. Here’s what to know about each:
The IRS considers public charities to be inherently accountable to the public because at least a third of their income comes from public sources. Examples include religious organizations, hospitals, schools, colleges, universities, health organizations, food banks, housing assistance organizations, and human rights organizations.
Public charities actively fundraise, and they have more flexible rules governing operations and more generous tax deduction limits for donors.
A private foundation is a charitable organization that is funded from few sources, derives income from investments and makes grants to other charitable organizations. Foundations are more closely regulated than public charities. For example, the assets must not be endangered, and funds can’t be used for noncharitable purposes, such as political activities.
High-net-worth and ultra-high-net-worth individuals and families may establish a private foundation as part of a family office.
These private foundations use their assets to conduct programs and activities rather than give out grants to public charities. Examples include museums, zoos, research facilities and libraries.
Setting up a private foundation is a good way to maximize philanthropic impact while gaining tax savings and estate-planning advantages. The threshold for starting a private foundation is generally $500,000, if it’s administered by a third party. Donors enjoy many tax benefits:
Let’s look at some other giving vehicles.
A donor-advised fund is sponsored by a public charity. The donor makes an irrevocable contribution to the public charity of cash, securities, mutual funds and sometimes non-publicly traded assets like real estate or company stock. The contribution generates a current-year tax deduction. The donor can recommend how the assets are invested, and the resulting income stream sustains the fund.
The public charity then uses investment income to fund its operations. The donor advises how they want the charity to use the money, but the nonprofit has the final say.
An irrevocable charitable trust allows the donor to leave some or all their estate – cash, securities, real estate and tangible assets such as artwork – to a 501(c)(3). As such, it can play an important role in estate planning. There are two types.
A charitable remainder trust, or CRT, splits assets between non-charitable and charitable beneficiaries. A CRT generates a tax-exempt income stream for the donor and beneficiaries. When the beneficiaries die, the remaining funds pass to the charity.
A charitable lead trust, or CLT, does the opposite: It generates an income stream for the named charitable beneficiary, with remaining funds going to non-charitable beneficiaries. CLTs are not tax-exempt.
A pooled income fund ensures a perpetual income stream, allows the donor to claim a current year tax deduction and makes a future gift to charity. It’s a type of mutual fund established by a 501(c)(3). The fund’s annual income is allocated to the participants, depending on the number of shares they hold. Named beneficiaries (which can include the donor) receive income for life. When the beneficiary dies, the shares are withdrawn and used by the nonprofit.
Leaving a philanthropic legacy takes expertise in tax- and estate-planning for a donor to do well while doing good. Cope Corrales assists its clients with charitable and philanthropic planning as part of a sound financial plan. This fiduciary wealth advisor provides independent experts, conflict-free proprietary investments and strategies for a wide range of financial needs.
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