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by Robert F. Sharpe, Jr.
One of the items included in
the President’s proposed budget
has given rise to a great
deal of discussion in the press and
elsewhere—namely the proposal to
raise taxes on the wealthy by taxing a
portion of the amount of income they
give for charitable use.
Unfortunately, few commentators
have correctly interpreted what
the actual impact of the proposed
changes would be. Some have said
that the bill would reduce the amount
that the wealthy could deduct from
35% of their gift to 28%. Others have
said the savings would be reduced
from 35% to 28%. Many of the
descriptions are flawed in various
ways; some are simply erroneous
and/or misleading.
By the time you are reading
this article, the issue may have been
decided. If the proposed changes have
become law, then take a moment to
read on to understand what this may
mean for fund raising in the future.
If the provision has been dropped,
then continue reading for a primer on
how the charitable deduction actually
affects the cost of a charitable gift.
If the matter is still in flux, then we
hope what follows will be helpful to
readers in forming their opinion of
the proposal—positive or negative.
Starting at the beginning
Let’s start with the difference
between a tax “credit” and a tax “deduction.” Tax credits allow for a
relatively straightforward reduction
in the amount of tax paid to the
government. For example, suppose
I earn $100,000 in a given year. If
my federal tax rate is 25%, my tax
bill would be $25,000. Now imagine
there is a tax credit of up to $10,000
for amounts given for charitable
purposes. As a “credit,” that amount
would be offset against my tax bill
and would lower it from $25,000 to
$15,000. After taxes, the $10,000
I donated to charity would cost
me nothing, as I would have paid
the $10,000 to the government in
taxes had I not donated it to charity.
Thus, a credit is the strongest of
the various available tax incentives.
Unfortunately, as the law stands
today, tax credits are not awarded for
charitable gifts.
Under our current system, charitable
gifts, within certain limits, are
instead allowed as “deductions” from
income before the tax rate is applied.
In the example above, I would report
$100,000 in gross income and take
a charitable deduction of $10,000,
leaving a taxable income of $90,000. I
would then owe only $22,500 in taxes
instead of $25,000. The deduction
would result in tax savings of $2,500
and reduce the cost of my gift to
$7,500. The $7,500 is called the “cost”
of the gift because I would have
been able to spend, save, or give that
amount to loved ones had I not made
the charitable gift.
The formula to determine the
after-tax cost of a charitable gift of
cash is Gift – T(Gift) = Cost, where
T is the tax rate. Because my tax rate is 25%, my cost is $.75 per dollar
given. If my tax rate were 40%, my
cost would be $.60 on the dollar. If my
rate were 10%, my cost would be $.90.
The higher the tax bracket, the lower
the after-tax cost of the gift. The cost
of making a gift is lower for persons
in higher tax brackets only because
they would owe more in tax if the dollars
were not donated to charity.
Another way to look at it is that
Congress is giving up more revenue
when a wealthy person makes a gift
than when a lower-income person
gives to charity. Under the current
system, however, in no event does a
donor at any income level actually
pay income tax on the deductible
amount given to charity.
Some have argued that it is
unfair that the government gives up
more revenue when a wealthy person
gives than when gifts are made by
others. Others point out that it is not
fair that wealthy persons should have
a lower after-tax cost of giving than
others. Those two concerns are at the
root of the administration’s proposal
to limit the tax benefits of higher-income
taxpayers to only the tax
savings they would enjoy if they were
in a 28% tax bracket. That way the
government gives up no more than
28% per dollar donated, regardless of
the donor’s tax bracket. It also means
that the cost per dollar donated by the
wealthy would be no less than $.72
per dollar donated even if they were
in a higher tax bracket—or does it?
To get to the heart of the issue, it
is important to return to the perspective
of a donor considering making
a gift. Let’s take the case of Ms.
Greene. After looking at her overall
finances, she decides to make a cash
gift of $10,000 to her favorite charity.
Regardless of her tax bracket, she
must allocate $10,000 in cash to fund
the gift.
Recall Ms. Greene has an income
of $100,000. If she decides to give
$10,000 to charity, invest $10,000
in mutual funds, pay taxes on the
amount not donated to charity, and
spend what remains, here is what
her “budget” would look like:
Under current law, no tax is due
on the amount given to charity, which
is the case under current tax law.
Now suppose Ms. Greene sees her tax
rate increase on all of the income she
did not give to charity. Her tax bill
would then go up even if the amount
donated remained the same. When
taxes increase, then her spending,
savings, or giving must decrease
to keep the total outlays within
$100,000.
But suppose instead of raising
taxes on all income, Congress
decides to impose a targeted tax
increase. Imagine Congress accomplishes
this by limiting the amount
of revenue it is willing to forego on
amounts donated by the wealthy. In
effect, this is what the administration’s
budget proposal would do.
How does it work?
Despite reports to the contrary
in the media, no one is proposing
limiting the amount that can be
deducted for charitable gifts. The
press in some cases has inaccurately
reported that Congress would limit
the amount that is deductible from
35% to 28%. That is not the case.
Under the proposed legislation, a
donor would still deduct the same
amount as before, subject to normal
adjusted gross income (AGI) limitations.
What is limited is the amount
of revenue Congress would give up
as a result of the gift.
For example, suppose a taxpayer
in the 35% tax bracket reports
$100,000 in income taxed at that
rate and donates $10,000 to charity.
Under current law, this donor would
deduct $10,000, reduce his taxable
income by that amount, and lower
his taxes by $3,500. If the maximum
tax bracket were reduced to 28%, he
would still deduct $10,000 but save
only $2,800 in taxes.
Under the proposed changes,
even though the donor is in the 35%
tax bracket, Congress would pretend
his maximum tax bracket is 28%
when he takes his charitable deduction.
The donor would then be able
to reduce his taxes by only $2,800,
not $3,500—a difference of $700.
This donor would still owe $700
in taxes. Therefore, he may give
$10,000, take a tax deduction of
$10,000, and still owe an additional
$700 when the final bill is computed.
This proposal does more than
simply raise or lower tax rates in
general. For the first time, the federal
government is considering taxing
income that is given to charity.
Possible implications
Let’s return to our donor above.
If he had budgeted $10,000 to make
charitable gifts, he would now have to
budget $10,700 to make a $10,000 gift.
The additional $700 to be paid
in taxes means he will have less to
spend, invest, or give to loved ones.
The only other alternative to keep
his budget in balance is to reduce the
gift amount from $10,000 to $9,346.
He would retain the $654 difference
to cover the additional tax due on the
$9,346 he donated.
Any way you look at it, Congress
is raising the cost of the gift in terms
of cash outlay by approximately 7%.
If passed by Congress, the proposed
changes would come into
effect in 2011, the same year that,
in another proposal, the maximum
tax rate may be raised to 39%. The
proposed tax increase would widen
the “spread” between the maximum
income tax rate (39%) and the rate
at which charitable gifts may be
deducted (28%) to 11%. A $10,000 gift
would require $11,100 in income. If,
given budget concerns, only $10,000
is available for the charitable gift, the
actual gift to charity would need to be
reduced to roughly $9,100, with the
remaining amount paid in taxes. In
this case the impact on larger campaign
gifts could become more significant. Imagine how a donor
would feel if faced with writing a
check to the IRS for $111,000 to cover
the tax on a $1 million fund-raising
campaign contribution.
It is unclear how higher-income
taxpayers will react to such changes,
but it is certain that their accountants
will see it as part of their
professional role to explain this
change and advise them how the
“numbers” will work in their case.
Consider the similarities between
this situation and the historical
impact over the decades of the 50% of
AGI limit. How many times have you
heard a donor say, “I can’t give any
more this year. My accountant tells
me I have given all I can deduct.”
Donors tend to cut their giving when told they owe tax on any amounts
donated beyond the AGI limits.
In the case of this proposed
change, however, higher-income
donors and their accountants will
not be able to avoid paying tax on
amounts they donate to charity by
monitoring their proximity to the
50% of AGI limit. Affected taxpayers
will find that none of the dollars that
are subject to the rule are deductible
at full value.
The stated intent of the proposed
tax law changes is to raise taxes on
the wealthy. Whether that is advisable
is beyond the scope of this article. This
increase is slated to be accomplished,
however, not through an across-the-board
increase in tax rates on the
wealthy but rather by imposing a targeted tax increase on amounts
donated to charity by people with
incomes over roughly $250,000. By
that standard, this tax could impact
a couple with mid-management jobs
in high-cost areas of the country; it
is certainly not a tax that will affect
only the megarich.
No one can really predict the
implications of this bill because
there is no precedent for it. It would
surely affect some charities more
than others. Those with the strongest
ties to donors would likely fare
the best, with the impact felt most
by charities to which donors may be
giving solely out of social obligation
or other less compelling motivations.
Again, our intention is simply to
explain the structure and possible
impact of the proposal, not to take
a position on the advisability of this
change. Regardless of what happens,
charities will have to find a way
to adjust to the resulting funding
changes through budget reductions
or other means.
If the issue is still in flux at the
time you are reading this article,
however, take a few minutes to
reflect on what this proposal would
really accomplish. Once you have
decided how you feel about it,
exercise your right to contact your
representatives and make your
opinion known.
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