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On May 28th, President
Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003.
The stated goal was to stimulate a sluggish economy by providing federal income
tax relief for many Americans. The primary thrust of the bill is to accelerate
income tax rate cuts that were already planned for coming years as part of the
provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001. It
also contains a number of other changes to our nation’s tax laws, some of
which can be expected to affect the ways in which larger charitable gifts are
structured.
The recent Tax Act
does not, however, directly address charitable giving. During the negotiation
process in Congress, lawmakers carefully structured the bill to disassociate it
from the charitable giving provisions contained in the CARE Act and similar
bills introduced in recent months that are specifically designed to stimulate
charitable giving. As a result, for example, the bill did not change the tax
treatment of gifts from IRAs and other retirement plans, and did not provide for
a deduction for non-itemizers or other measures designed to encourage charitable
giving. (As we go to press, the CARE Act and similar bills are under
consideration in the House and Senate, with their eventual fate still unknown.)
The bill also made no changes in the schedule for the reduction and/or eventual
elimination of gift and estate taxes that were an integral component of the 2001
Tax Act.
The primary provisions
of the 2003 Tax Act are listed below:
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Decreases in
income tax rates. The maximum ordinary income tax bracket for 2003 will be 35%,
down from 38.6%. The brackets above 15% will be reduced to 33%, 28%, and 25%.
Other changes apply to lower tax brackets that will result in tax reductions for
persons subject to those rates as well.
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Relief from the
“marriage penalty” for many taxpayers.
-
Lower taxes on
capital gains and dividend income.
-
Increase in the
amount of the childcare credit.
-
Reduction of the
impact of the alternative minimum tax.
-
Incentives for
investment in business equipment.
Although it does not
directly target charitable giving, the recent Tax Act can still be expected to
have an impact on the way gifts, especially larger ones, are structured.
First,
by lowering tax rates, the net cost of a deductible charitable gift is
increased. The formula for determining the after-tax cost of a charitable gift
is as follows:
Cost = Gift – (T x
Gift),
where T equals the
applicable tax rate
Thus, the cost of a
gift of $1,000 to a person in a 38.6% tax bracket would be $1,000 – (38.6% x
$1,000), or $614, some 61.4% of the amount donated. With the reduction of the
maximum tax rate to 35% for 2003, the formula would yield a maximum cost of
$650, or 65% of each dollar donated ($1,000 – 35% x $1,000).
With gifts of
appreciated assets, the formula is somewhat different:
Cost = Gift – (T x
Gift) – c(Gift – Cost Basis),
where T equals the
applicable ordinary income tax rate and c equals the applicable capital gain tax
rate.
In the previous
example, if a donor instead gave stock worth $1,000 with a cost basis of $200, under prior law the
minimum cost would be $1,000 – (38.6% x $1,000) – 20% x ($1,000 - $200), or
$454 (45.4% of amount donated). Under the new law, as a result of reductions in
both the ordinary income tax rate (from 38.6% to 35%) and the capital gain tax
rate (20% to 15%), the cost of the gift described above would be $1,000 – (35%
x $1,000) – 15% x ($1,000 - $200), or $530 (53% of amount donated).
In these examples, the
cost of the gift of cash by the highest bracket taxpayers will rise by 6% and
the cost of a gift of the appreciated stock by 17%.
In the case of zero
basis stock where the savings would be the greatest, the minimum cost of such a
gift will rise from 41.4% of each dollar donated to 50% per dollar donated, an
increase of 21%.
While the after-tax
cost of certain charitable gifts will rise under the provisions of the recent
Tax Act, it is important to remember that the costs of various types of gifts
are relative; it will, for example, still cost as much as 30% more to make a
gift in the form of cash rather than appreciated assets.
 Despite a predictable
and understandable litany of nay-saying in contemporaneous press reports,
increases in the after-tax cost of charitable gifts in the past as a result of
lower tax rates have not demonstrably affected the amount of charitable giving.
This fact is reflected in trends in gifts by individuals reported by Giving USA
for the years following reductions in maximum income tax rates brought about by
past tax bills. See chart at right.
The message for donors
is twofold. First, lower tax rates will make more cash available to donors for
charitable gifts and other discretionary transfers of cash and other assets.
Nonprofits should take this opportunity to encourage donors to use a portion of
their after-tax income to support their charitable interests. Second, for those
who have appreciated property, it still makes the most sense to donate the
property and use cash to diversify investments. Don’t forget that many donors
may now have increases in the value of bonds or bond funds as interest rates
have fallen in recent years.
Perhaps the most
important impact of the new tax law for fundraisers is in the area of deferred
planned gifts. Reductions in the rate of tax on capital gains and dividend
income can actually serve to make certain types of gifts more attractive.
Gift annuities
For example, when
donors fund charitable gift annuities with appreciated assets, a portion of each
payment is taxed as capital gain for a period of time equal to their life
expectancy. Lower capital gains tax rates mean they can keep more of the
payments and achieve a higher after-tax yield than before. In some cases, this
can be more than enough to offset lower annuity payment rates recommended by the
American Council on Gift Annuities (ACGA) as of July 1, 2003.
 Consider a 75-year-old
funding a gift annuity with $50,000 worth of stock that has a cost basis of $20,000. The chart on
the right highlights the difference between a gift annuity
established before and one funded after the recent ACGA rate changes and federal
tax law changes.
Note that in this
case, reductions in tax rates actually enable the donor to net more after taxes
from a new gift annuity, even considering the reduction in rates recommended to
go into effect on July 1.
Charitable remainder
trusts
Similar results can be
realized by taxpayers who fund charitable remainder trusts with appreciated
assets. Under the so-called “tier structure” mandated for reporting income
from charitable remainder trusts, the nature of income as realized within the
trust maintains its character when reported on the recipient’s tax return.
Thus, the percentage of income that retains its capital gain status may be taxed
at a lower rate than under prior law. This will serve to make charitable
remainder trusts funded with appreciated property even more attractive than
before.
Consider also the
impact of reducing the tax on dividend income. Presumably, dividend income will
still enjoy its favored treatment when received by the income beneficiary of a
charitable remainder trust. If this is in fact the case, then a donor may prefer
a charitable remainder annuity trust to a gift annuity that pays the same rate
if it is anticipated that the trust will yield dividend income that will be
taxed at lower rates under the new tax law. The ordinary income element of a
gift annuity payment, on the other hand, is taxed at full ordinary income tax
rates with no differentiation of any portion of ordinary income derived from
dividends.
While this may be an
esoteric point, it is a helpful distinction when an institution is approached by
a younger donor seeking a gift annuity that would offer relatively high
payments. There may now be tax savings justifications that would lead the donor
to opt for a charitable remainder annuity trust where liability is limited to
trust assets and the gift does not amount to a general obligation of the
charity.
In funding charitable
remainder trusts and certain other split interest gifts, it may also be helpful
to note that some assets will still be subject to much higher capital gains tax
rates than 15%. For example, the amount of gain in real estate represented by
the difference between the original cost basis and amounts deducted in the past
as straight-line depreciation will be taxed at 25%. The gain in tangible
personal property such as jewelry, art, and other collectibles will continue to
be taxed at 28%. Thus, in appropriate circumstances, these types of assets may
be better choices for funding gifts than property that would be taxed at lower
rates if sold.
Charitable lead trusts
Lower taxes on capital
gain and dividend income may also lead to increased interest in charitable lead
trusts. Donors holding large amounts of appreciated property may be more likely
to sell the property, pay historically low capital gain tax rates, and place the
net proceeds in a lead trust. This amounts to, in effect, paying a 15% capital
gain tax on part of the value of the assets rather than gift and estate taxes of
up to 49% on the entire value of property transferred directly to non-charitable
recipients.
The new law may also
lead to increased interest in a plan sometimes referred to as a “Super CLAT,”
under which a grantor lead trust enables a donor to remove an asset from his or
her estate and enjoy a tax deduction today against an income tax rate as high as
35% while reporting income in later years that may be taxed at favorable capital
gain and dividend tax rates. This latter point is another example of the subtle
nature of the impact of the new Tax Act on charitable giving.
As always, it is
important to make certain that staff, volunteers, donors, and other
constituencies receive the information they need in order to understand the
impact of tax legislation on charitable giving. Sometimes the message is clear
and direct; sometimes it is not as readily apparent. The impact of this law may
seem negligible on the surface, but can have powerful implications for the
funding and subsequent allocation of assets in the case of split interest gifts
such as gift annuities, charitable remainder trusts, and lead trusts.
In communicating with
donors, it is appropriate to make observations about the positive impact lower
taxes can have on charitable gifts. Take the time to remind them that gifts of
appreciated assets remain more advantageous than cash gifts. When making
proposals for deferred gifts, help donors carefully consider which assets will
help them take full advantage of the provisions of the new Tax Act.
By their very nature, tax law changes such as the one just signed into law alter
the fund-raising landscape. Fundraisers that stay informed, remain resourceful,
and help their donors navigate the new tax laws will chart a safe course to the
future.
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