Charitable gifts can reduce estate taxes. For every dollar a person gives to charity, the IRS provides for a dollar-for-dollar deduction from the value of the estate.
1. The Value of Charitable Gifts.
For example, Martha, who owns assets worth $14,000,000, gives $1,000,000 to the Mount Baker Chapter of the American Red Cross in 2020. The remainder of her estate is distributed to her two children. Martha’s estate pays estate taxes of approximately $3,487,000 and each of her children receives approximately $4,756,500.
In comparison, Martha gives her entire $14,000,000 estate to her two children. Martha’s estate pays estate taxes of approximately $4,007,000. Each of Martha’s children receives approximately $4,996,500.
The $1,000,000 gift made in the first example reduces Martha’s estate taxes by $520,000. The share of each of Martha’s children is reduced by $240,000.
People may use several different estate planning tools to gift their assets to charitable organizations. Depending on how much control the donor wants to keep and the donor’s purposes in making the gift, the best way to make a charitable gift changes.
2. Gifts at the Time of Death.
A person can make charitable bequests in their wills or revocable living trusts in four principal ways:
a. By giving the charity a fixed dollar amount.
For example, I give the sum of $10,000 to the Whatcom Hospice Foundation, Bellingham, Washington.
b. By giving the charity a fixed percentage of the assets of the estate.
For example, I give 10% of my estate to Whatcom Community Foundation to assist in providing educational opportunities to financially needy students.
c. By giving the charity the remainder of the estate.
For example, I give the remainder of my estate to Junior Achievement, for the use in Whatcom County, Washington.
d. By giving the charity a contingent gift.
For example, I give the remainder of my estate to my spouse. If my spouse fails to survive me, I give the remainder of my property to The Western Foundation, Bellingham, Washington.
3. Use of Retirement Plans for Charitable Gifts.
If a person owns an individual retirement account, a 401(k), 403(b) or a TIAA-CREF account and wants to make a charitable donation, then the taxpayer should name the charity as the primary beneficiary. A charitable beneficiary named on an individual retirement account does not pay income tax on the amounts distributed to the charitable beneficiary. An individual or an estate will pay income tax on any distributions received from an individual retirement account.
For example, Martha owns assets of $1,500,000, including an IRA worth $400,000. Martha wants to make a charitable gift of $400,000. If Martha names her estate as the beneficiary of the retirement plan and then names the charity as a beneficiary under her will, the estate will pay income taxes on the $400,000 before it is distributed to the charity. The income tax will be approximately $156,000 if the estate collects the IRA in one year.
If, instead, Martha names the charity as the beneficiary of the IRA, then neither her estate nor the charity pays income taxes on the IRA amount for a tax savings of approximately $152,000. In addition, the estate does not pay any estate tax on the gift of the IRA to a charity.
4. Charitable Remainder Trusts in Wills.
Wills can also contain charitable remainder trusts and charitable lead trusts that split an interest that an intended beneficiary receives with a charity.
There are two types of charitable remainder trusts (“CRT”): a charitable remainder annuity trust (“CRAT”) and a charitable remainder unitrust (“CRUT”).
A CRAT pays a fixed amount each year. The CRAT must pay out at least 5% of the initial trust value each year. Even if the value of the CRAT increases or decreases, the income beneficiary receives the same fixed amount each year.
For example, David wants his child, Chris, to receive an income stream of $15,000 per year for life, but wants the remainder of this gift to go to Whatcom Community College Foundation. David creates a CRAT containing $300,000 that pays Chris $15,000 a year. When Chris dies, Whatcom Community College Foundation receives the remainder of the trust. David’s estate will receive a charitable deduction for this gift.
A CRUT pays out a fixed percentage of the trust assets each year. Generally, a CRUT must pay out a percentage equal to at least 5% of the value of the trust each year. Some CRUTs with appropriate trust language can pay out the lesser of a fixed percentage or net income of the trust. The income beneficiary receives an amount each year based on the value of the trust assets at that time.
For example, David wants to give $300,000 to Lutheran Campus Ministries but wants his child, Chris, to receive an annual income interest for her life. David believes that based on the past performance of the stock market, the value of the CRUT will increase each year. David creates in his will a CRUT that pays Chris 5% each year while she is alive. If the value of the trust increases to $350,000, then Chris will receive $26,250. If the value of the CRUT decreases to $250,000, then Chris will receive $18,750. When Chris dies, the trust remainder will be distributed to Lutheran Campus Ministries.
A CRT can last for a period up to 20 years or for the lifetime of a beneficiary.
5. Charitable Lead Trusts in Wills.
A taxpayer can also use a charitable lead trust (“CLT”) to benefit a charity. A charitable lead trust functions in a similar manner to a charitable remainder trust, except the charity receives the income interest and the intended beneficiary receives the remainder after a period of years.
6. Life Insurance.
A person can name a charity as either the primary or the secondary beneficiary on a life insurance policy. Naming a charity as the beneficiary is most beneficial when the life insurance is subject to estate taxes.
7. Outright Lifetime Gifts.
If a taxpayer has sufficient assets, lifetime gifts can be more satisfying than gifts at the time of death, since the donor can see his or her money at work.
A taxpayer can gift cash or appreciated property to a charity during life. A lifetime charitable gift allows a taxpayer to deduct up to 60% of his or her taxable income each year if the gift is to a public charity.
For example, Martha gifts $100,000 to the Whatcom Family YMCA. She has taxable income of $50,000. She can only use $30,000 of her charitable deduction in the year of the gift. She can carry the remaining $70,000 over to offset her income in the next five years up to 60% of her taxable income each year.
The charitable deductions for gifts to private foundations are limited to 30% of the donor’s taxable income.
8. Use of Appreciated Property.
Appreciated property makes an excellent gift to a charity because the charity pays no capital gains on the sale of the property, in comparison to an individual who pays capital gains.
For example, Martha owns some publicly traded stock that she purchased for $5,000, but it is currently worth $1,000,000. Martha wants to make a gift to a charity. Martha sells the stock for $1,000,000 and she pays capital gains of $199,000 plus the 3.8% surtax which would be at least $28,500 if she had no other income. If she gifted the net amount to the charity after paying the taxes, the charity will receive $772,500. She will receive a charitable deduction of $772,500 for a tax savings of $285,825 if she is in the 37% income tax bracket.
In comparison, Martha gifts the stock to the charity. She receives a charitable deduction of $1,000,000 for a tax savings of $370,000 if she is in the 37% income tax bracket. The charity will receive $1,000,000 and will not pay any capital gains tax on the sale of the stock.
The gift of the appreciated stock gives the charity at least $227,500 more, since the charity pays no capital gains tax or the 3.8% surtax. Martha receives an additional $84,175 in income tax savings.
However, the individual donating the appreciated property is limited to a deduction of 30% of his or her taxable income for each year. Any excess deduction can be carried forward on the individual’s tax return for up to five years.
9. Lifetime Charitable Remainder Trust.
If a person wants to make a charitable gift currently but needs more annual retirement income, the person may consider a charitable remainder trust. A person can use either a CRAT or a CRUT.
For example, David wants to give $200,000 to charity but wants to retain an income stream of $15,000 a year for life. David creates a CRAT which pays him $15,000 each year while he is living.
For example, David wants to give $200,000 to charity but wants to retain an annual income interest. David believes that based on the past performance of the stock market, the value of the CRUT will increase each year. David creates a CRUT that pays him 7.5% each year while he is living. If the value of the trust increases to $220,000, then David will receive $16,500. If the CRUT decreases to $180,000, then David will only receive $13,500.
A person can structure a CRT to maintain significant control of the trust. For example, the person can retain the ability to change the charitable beneficiaries or act as the trustee, provided the trust does not contain difficult to value property (i.e., real estate).
A CRT also works well to avoid capital gains and increase income for people with appreciated property since a CRT does not pay capital gains tax when the trust sells the appreciated property. The CRT does not pay any income tax; however, the beneficiary of the CRT pays income taxes on the distributions received from the CRT.
For example, Martha owns publicly traded stock worth $1,000,000 that she originally purchased for $5,000. If Martha sells the stock for $1,000,000, she will pay capital gains taxes on $995,000. Assuming it is all taxed at the 20% capital gains tax bracket, she will pay capital gains taxes of $199,000 plus she will pay the 3.8% surtax which would be at least $28,500 if she had no other income. She will retain $772,500 at most. If she invests the $772,500 and receives an annual return of 6%, she will receive $46,350 each year.
In comparison, if Martha places the $1,000,000 into a charitable remainder unitrust with a 6% payout, then she will receive $60,000 each year. Neither Martha nor the CRUT will pay any capital gains taxes on the sale of the stock. Martha will also receive a charitable deduction of $321,250 if she made the gift in May of 2020 when she was 60 years old. Note: Martha will pay income taxes on the $60,000 payout that she receives each year, a portion of which may be capital gains if it is partially trust principal.
The actual amount of the income tax deduction depends on several factors, including the age of the beneficiary of the CRT, the value of the property, the income payment percentages, the trust term, actuarial factors and a federal interest rate that changes monthly.
Note: The alternative minimum tax may affect certain people donating their property to charity and alter the normal income tax deductions available.
10. Conservation Easements.
A conservation easement allows a person with valuable farm or timber land to place restrictions on the use of the land that reduces the value of the land. Conservation easements can provide valuable income tax deductions, property tax relief and gift and estate tax reductions. A person creates a conservation easement by giving a valuable right (i.e., the right to subdivide the property) to the government or a public charity such as the Whatcom Land Trust or San Juan Preservation Trust.
The property must meet two requirements:
1. The property must be owned by the donor or a member of the donor’s family at all times during the three-year period ending at the time of the gift. A donor can also provide for a conservation easement in his or her will, provided that the donor owned the property for the three years prior to the donor’s death.
2. The transfer of the restriction must provide for some conservation purpose. The following are considered conservation purposes:
a. Conserving land areas for outdoor recreation or education of the general public.
b. Protecting relatively natural habitat of fish, wildlife or plants, or similar ecosystems.
c. Preserving a historically important land area or a certified historic structure.
d. Preserving an open space if it is either pursuant to a clearly delineated government policy and will yield a significant public benefit, or for the scenic enjoyment of the general public and will yield a significant public benefit. Not every property parcel will meet the requirement for conservation purposes.
For example, David and Martha own 40 acres that look out over the San Juan Islands. In addition, much of the 40 acres contains harvestable timber. David and Martha want to give a conservation easement to the Whatcom Land Trust that restricts any future owners’ rights to subdivide the land and build more than one house on the property. In addition, they want to limit the right to harvest the timber. If the Whatcom Land Trust accepted the gift, then David and Martha would meet the requirements of a conservation easement.
If, in comparison, David and Martha live in a house built in the 1970s on a city lot that is surrounded by other houses built in the 1970s, then a gift of the right to only have one house and a restriction on the right to harvest any timber would not qualify for a conservation easement, since the restrictions would not meet the conservation purposes test.
A person with a qualified conservation easement receives an income tax deduction if the gift is made during life. The value of the deduction is calculated by having the property appraised for the fair market value before the addition of the restrictions and having it reappraised after the restrictions have been placed on the property. The difference between the value of the property prior to the conservation easement and the fair market value of the property after the conservation easement provides for the amount of the donor’s charitable deduction.
For example, David and Martha own 40 acres that overlook the San Juan Islands. The value of the property before any conservation easements are placed on it is $1,500,000. After David and Martha restrict the size of any house on the property to 2,500 square feet and the harvesting of any timber, the property is valued at $800,000. The deduction that is available to David and Martha is $700,000. Depending upon their income, they may or may not be allowed to use that deduction.
Property subject to conservation easements can also provide estate tax benefits. If a donor dies owning property subject to a conservation easement, then the fair market value of the property subject to the conservation easement will be reduced either by the lesser of 40% or $500,000 in years after 2002.
Conservation easements help people obtain an exclusion from estate taxes for property that they would like to maintain as open space or forest land for future generations.
11. Other Options.
Other options for lifetime gifts include pooled income funds, donor advised funds, charitable lead trusts and private foundations.
A person who wants to receive an income stream from his or her charitable gift but has less than $250,000 to give to a CRT may want to consider using a pooled income fund or a gift annuity.
A person who wants to make a current outright charitable gift but wants to retain the right to change the beneficiary of the charitable gift annually may want to consider a donor advised fund.
A person who wants to maintain control of the funds given to charity and wants a current charitable deduction for income taxes may also consider a private foundation.
A charitable gift can provide valuable estate and income tax benefits. A charitable gift allows a person with a taxable estate to direct his or her money away from the government and into the programs that the person supports. The options discussed here are merely a few of the many ways that people can donate their assets to the charity of their choice.