Charitable giving can play an important role in many estate plans. Philanthropy cannot only give you great personal satisfaction, it can also give you a current income tax deduction, let you avoid capital gains tax, and reduce the amount of taxes your estate may owe when you die.
There are many ways to give to charity. You can make gifts during your lifetime or at your death. You can make gifts outright or use a trust. You can name a charity as a beneficiary in your will, or designate a charity as a beneficiary of your retirement plan or life insurance policy. Or, if your gift is substantial, you can establish a private foundation, community foundation, or donor-advised fund.
Making outright gifts
An outright gift is one that benefits the charity immediately and exclusively. With an outright gift you get an immediate income and gift tax deduction.
Make sure the charity is a qualified charity according to the IRS. Get a written receipt or keep a bank record for any cash donations, and get a written receipt for any property other than money.
Will or trust bequests and beneficiary designations
These gifts are made by including a provision in your will or trust document, or by using a beneficiary designation form. The charity receives the gift at your death, at which time your estate can take the income and estate tax deductions.
Another way for you to make charitable gifts is to create a charitable trust. You can name the charity as the sole beneficiary, or you can name a non-charitable beneficiary as well, splitting the beneficial interest (this is referred to as making a partial charitable gift). The most common types of trusts used to make partial gifts to charity are the charitable lead trust and the charitable remainder trust.
There are expenses and fees associated with the creation of a trust.
Charitable lead trust
A charitable lead trust pays income to a charity for a certain period of years, and then the trust principal passes back to you, your family members, or other heirs. The trust is known as a charitable lead trust because the charity gets the first, or lead, interest.
A charitable lead trust can be an excellent estate planning vehicle if you own assets that you expect will substantially appreciate in value. If created properly, a charitable lead trust allows you to keep an asset in the family and still enjoy some tax benefits.
How a Charitable Lead Trust Works
John, who often donates to charity, creates and funds a $2 million charitable lead trust. The trust provides for fixed annual payments of $100,000 (or 5% of the initial $2 million value) to ABC Charity for 20 years. At the end of the 20-year period, the entire trust principal will go outright to John’s children. Using IRS tables and assuming a 2.0% Section 7520 rate, the charity’s lead interest is valued at $1,635,140, and the remainder interest is valued at $364,860. Assuming the trust assets appreciate in value, John’s children will receive any amount in excess of the remainder interest ($364,860) unreduced by estate taxes.
Charitable remainder trust
A charitable remainder trust is the mirror image of the charitable lead trust. Trust income is payable to you, your family members, or other heirs for a period of years, then the principal goes to your favorite charity.
A charitable remainder trust can be beneficial because it provides you with a stream of current income — a desirable feature if there won’t be enough income from other sources.
How a Charitable Remainder Trust Works
Jane, an 80-year-old widow, creates and funds a charitable remainder trust with real estate currently valued at $1 million, and with a cost basis of $250,000. The trust provides that fixed quarterly payments be paid to her for 20 years. At the end of that period, the entire trust principal will go outright to her husband’s alma mater. Using IRS tables and assuming a 2.0% Section 7520 rate, Jane receives $50,000 each year, avoids capital gains tax on $750,000, and receives an immediate income tax charitable deduction of $176,298, which can be carried forward for five years. Further, Jane has removed $1 million, plus any future appreciation, from her gross estate.
Private family foundation
A private family foundation is a separate legal entity that can endure for many generations after your death. You create the foundation, then transfer assets to the foundation, which in turn makes grants to public charities. You and your descendants have complete control over which charities receive grants. But, unless you can contribute enough capital to generate funds for grants, the costs and complexities of a private foundation may not be worth it.
A general guideline is that you should be able to donate enough assets to generate at least $25,000 a year for grants.
If you want your dollars to be spent on improving the quality of life in a particular community, consider giving to a community foundation. Similar to a private foundation, a community foundation accepts donations from many sources, and is overseen by individuals familiar with the community’s particular needs, and professionals skilled at running a charitable organization.
Similar in some respects to a private foundation, a donor-advised fund offers an easier way for you to make a significant gift to charity over a long period of time. A donor-advised fund actually refers to an account that is held within a charitable organization. The charitable organization is a separate legal entity, but your account is not — it is merely a component of the charitable organization that holds the account. Once you transfer assets to the account, the charitable organization becomes the legal owner of the assets and has ultimate control over them. You can only advise — not direct — the charitable organization on how your contributions will be distributed to other charities.
What is the charitable deduction?
The charitable deduction allows you to deduct the value of property you give to charity from your estate and may reduce any federal gift and estate tax that may be owed. Charitable gifting allows you to satisfy your personal philanthropic desires and fulfill your estate planning objectives.
You may wish to give to the charitable community out of devotion, moral obligation, altruism, generosity, or a sense of responsibility. Or you may want to give because you believe you will do a better job of distributing your wealth than Uncle Sam. Whatever your motivation, charitable giving should be gratifying.
Gifts to charity can also fulfill your estate planning objectives. There are no limits on the amount that you can pass to charity. It is possible to transfer your entire estate to charity, tax free. Gifts to charity allow you to:
- Distribute your property tax free
- Potentially put the amount subject to estate taxes into a lower bracket
However, remember that property you give to charity is property that does not go to your heirs. Don’t let your attempt to save taxes have the unintended effect of depriving your heirs.
Charitable gifts are also deductible for income tax purposes for taxpayers who itemize. However, there is a limit imposed on the amount that can be deducted, and other adjustments may be required.
How does a gift or bequest of property qualify for the charitable deduction?
Certain conditions and requirements must be met to qualify for this deduction:
- You must make the transfer, either during life or at death by will, rather than your executor or heirs
- The property must be transferred to a qualified charity for a charitable purpose. A qualified charity includes:
- The United States, any state, the District of Columbia, and any local government
- Certain religious, scientific, or charitable organizations
- Certain veterans organizations
- Certain fraternal organizations
- An employee stock ownership plan if the transfer is a qualified gratuitous transfer of qualified employer securities
Gifts or bequests to individuals, no matter how needy or worthy the individuals are, cannot qualify for the charitable deduction.
The IRS publishes a list of charitable organizations (the Cumulative List) to which gifts or bequests will qualify for this deduction. The IRS does not define what a qualifying charitable purpose is. However, it has issued Letter Rulings that discuss what has been allowed or disallowed, and it has privately ruled that charitable purpose means the same for gift tax and estate tax purposes as it does for income tax purposes. Generally, a charitable purpose means a public purpose, as opposed to a private purpose.
- Depending on the year in which you die, the gift or bequest must be included in your estate for estate tax purposes. The amount of the deduction is the value of the property transferred, but the amount cannot exceed the value of the property that is required to be included in your estate.
- You must be a U.S. citizen or resident at the time you make the gift.
A charitable deduction is allowed for nonresident noncitizens, but only certain types of charities qualify.
- Generally, the gift must be a present interest. A present interest means that the donee (the person or organization you give to) has the unrestricted right to the immediate use, possession, or enjoyment of the property, or the income from the property, from the moment you make the gift. The deduction is not available to gifts of future interests in property.
“Future interests” is a legal term and includes reversions, remainders, and any other delayed interest that postpones the commencement of the use, possession, or enjoyment of the property, or income from the property.
Gifts of future interests may qualify for the deduction if the gift is structured as a partial interest gift. Partial interest gifts (property rights given to both charitable and noncharitable interests, e.g., a trust paying income to charity, with the remainder going to noncharitable beneficiaries) may qualify for the deduction if the donated property is transferred to an IRS-approved form of charitable trust, such as a charitable lead trust, charitable remainder trust, or pooled income fund.
How do you use the charitable deduction?
For lifetime gifts, the charitable deduction is allowed for the year in which the gift is made for federal gift tax purposes. You don’t need to file an annual gift tax return if all gifts made for a given year fully qualify for the charitable deduction.
Special rules regarding the charitable deduction
The amount of the charitable deduction is limited to the amount of the transfer actually made. Special rules apply if the transfer to charity first must bear a portion of any estate taxes because of the calculation difficulties that arise. Estate taxes are a function of the charitable deduction and the charitable deduction is a function of the estate taxes.
The interrelated computation can be avoided by providing a specific bequest to the charity, instead of a gift from the residuary estate.
An example of the use of the charitable deduction
Ron is a small-business owner in the town where he was born and raised. He is a well-liked and respected member of the community. Ron feels he should give back to his community and donates money every year to support the town’s zoo, hospital, library, children’s center, church, and other local charities.
During the years 2015 through 2019, Ron gave $500,000 in total to different charities. Each year, Ron filed a gift tax return but paid no gift tax because the gift tax charitable deduction offsets his taxable gifts. Each year, Ron also filed an income tax return, reducing his taxable income by the amount of income tax charitable deduction allowed. Say Ron dies in 2020 and that his will provides for a charitable bequest in the amount of $100,000, with the residuary estate passing to his only nephew, James. Ron’s executor reduces Ron’s taxable estate by $100,000 (allowed by the estate tax charitable deduction), which then reduces the estate tax owed. Ron’s executor pays the estate tax owed and then distributes the residuary estate to James.
Charitable IRA rollover gifts
Donors over the age of 70½ can make tax-free charitable distributions of up to $100,000 directly from their IRAs each year.
This provision for charitable IRA rollover gifts has been made permanent.
Donors who have reached age 70½ can direct amounts (subject to the aforementioned $100,000 limit) to charity in satisfaction of their minimum required distribution as long as the following requirements are met:
- The donor is age 70½ at the time the gift is made.
- The charitable gift is made directly from an IRA to the charity.
- An individual can give a maximum of $100,000 per year. A spouse can give an equal amount from his/her IRA.
- Individuals can make as many gifts in any amount to as many charities as desired as long as the total does not exceed $100,000 per year.
- The gift cannot be made in exchange for a charitable gift annuity or to a charitable remainder trust.
- The gift cannot be made to a private foundation, donor-advised fund, or supporting organization (as described in IRC Section 509(a)(3)).
The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.