Op-ed: How to Reduce the Risk of Tax Hikes from Charitable Donations
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Possible tax changes for wealthy and wealthy investors could lead to an increased tax burden. That said, there is motivation to find ways to protect this wealth.
Some solutions that reduce the risk of specific expected tax increases in Biden include charitable donations – a plus for charity. These vehicles include charitable residual funds and donor-advised funds.
CRTs are complicated arrangements that require lawyers to be set up and accountants to maintain. DAFs, much simpler and far cheaper, have become increasingly popular in recent years.
Both vehicles allow income tax deductions – carried forward in the current year or over five years – on cash deposits of up to 60% of the adjusted gross income of the donor and up to 30% of the AGI on assets brought in. These contributions can also reduce the size of taxable goods.
Apart from these similarities, the two vehicles are very different.
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These traits have added a new charm to many wealthy families as they wait to see if Congress approves Biden’s ambitious tax agenda for the top brackets. It is also possible that changes could significantly reduce the gift and estate tax exemption from the current $ 11.7 million.
CRTs channel the proceeds from assets into a tax-privileged stream of cash that goes to the donor or other designated non-profit beneficiary. This source of income flows for a fixed term or often for the life of the non-profit beneficiary.
According to the rules, these trusts must be designed in such a way that, at the end of this period, at least 10% of their money remains for a donation to a charitable organization designated from the start.
No tax is payable on the proceeds of the sale of trust assets until that money goes to the non-profit beneficiary, potentially years later. When assets are held by individuals, their sale generates capital gains tax in the year they are sold.
This difference creates a tremendous advantage for CRT donors as they can fund these trusts with highly valued assets and then manage them for optimal returns while minimizing tax exposure by adjusting the income stream to spread the tax burden over many years. That advantage would be compounded if the current Congress is expected to raise capital gains tax rates for high earners.
DAFs do not allow redistribution to non-profit beneficiaries. All contributions, including profits from contributed assets, must ultimately be donated to charity. For many donors, however, DAFs offer significant advantages, including:
- Simple creation. Most major financial services companies offer DAF accounts for individual customers. It is relatively easy to set up compared to the extensive legal work required to create CRTs.
- Significantly lower costs. Creating a CRT can cost thousands of dollars in legal fees, plus recurring fees from accountants for processing the required IRS filings and from financial advisors to manage the trust. In contrast, the fees charged by financial institutions to DAFs are usually between 0.1% and 1% per year, depending on the size, plus a small custody fee for maintaining the account.
- Lots of flexibility. Individuals or families can create a DAF, finance it and get the allowance in the same year. Then they can wait years to determine charitable beneficiaries and direct specific donations. With CRTs, donors have the pressure to identify charities in building trust. Such elections are complicated to change because they are irrevocable trusts, while DAFs allow for ongoing target review and regular family get-togethers about charity merits.
- Low barrier to entry. Generally speaking, a DAF can be funded with as little as $ 5,000 initially. With a CRT, in some cases, this amount may only cover half the legal costs to create it, let alone finance it.
- Great latitude in the types of assets that can be deposited. DAF contributions can include shares in privately held companies, collectibles such as art, or even cryptocurrency – provided the valuation methods comply with IRS rules. This gives donors more options to get tax deductions without having to raise cash as they can donate a wide range of assets that they may own.
- Help with listing tax deductions. For less affluent donors, a DAF is a way to qualify for listing tax deductions in a few years time rather than using the standard deduction. Because DAF donations are deductible in the year they are made, filers can aggregate donations, which they normally consider two years – possibly years later – for tax purposes in a single year. This allows them to meet the IRS threshold set out in the 2017 Tax Act to qualify for the breakdown of deductions. This feature, along with its simplicity and low cost, has resulted in the rapidly increasing use of DAFs. Contributions to this in 2019 (USD 38.8 billion) increased by 80% compared to 2015.
Meanwhile, as DAFs have grown in popularity, they have been criticizing them for getting a huge charity tax deduction without actually benefiting any charity for many years.
Actual grants from DAFs to qualified charities in 2019 of more than $ 25 billion represented a 93% increase over 2015. In addition, proponents say that the gaps between funding DAFs and channeling donations of donors have time to assess the merits of eligible charities. With CRTs, this delay can be a lifetime for adults. Being somewhat esoteric due to their lack of accessibility, CRTs tend to fly below the critical radar.
Which of the two devices works best depends on the individual’s situation – how much wealth needs to be protected, whether a source of income is desired and what charitable goals are being pursued.
– By David Robinson, CEO and Founder of RTS Private Wealth Management