Non-binding instructions may be only wishful thinking
If you’re like most charitably-inclined people, your generosity isn’t motivated exclusively by tax benefits, but they certainly appreciate the lower tax bill. Though many people assess their charitable giving from year to year to maximize their income tax savings, fewer exercise similar vigilance over charitable giving in their estate plans.
As recently as 2001, the estate tax exemption was just $675,000 and the top estate tax bracket was 55 percent. Prior to the American Taxpayer Relief Act of 2012, passed in the wee hours of January 1, 2013, the estate tax exemption was scheduled to drop to $1 million per person and reinstate the 55 percent top estate tax bracket. Because of the low exemption and high tax rates relative to the top income tax rates, including charitable bequests in your estate plan often generated the greatest tax savings.
However, with the federal estate tax exemption rising to $11.4 million per person in 2019, only a tiny fraction of taxpayers will owe any federal estate taxes at their death – regardless of the disposition of their estate. As a result, few decedents will see any tax benefits resulting from the charitable gifts in their estate plan. Instead, for many people the greatest tax savings in an estate plan comes from income tax savings for beneficiaries. As an alternative to traditional charitable gifts directed at death, some individuals may realize greater savings by leaving the money to their beneficiaries and allowing the beneficiaries to make the charitable donations. This can generate a valuable income tax deduction for the beneficiaries.
The greatest tax savings is for individuals and families that want to make large charitable gifts and have beneficiaries in high tax brackets, but there can be tax savings for smaller cases, too. Consider the following:
Laura has an estate valued at $1 million and would like to leave $100,000 to charity and the remainder to her son, John. John has income of $100,000 per year and pays a combined state and federal tax rate of 25 percent.
Option #1: Laura’s trust leaves $100,000 to charity off the top and the remaining $900,000 to John. John ends up with $900,000 and no income tax savings.
Option #2: Laura leaves everything to John. John donates $100,000 of the assets he inherited from Laura’s estate to charity. John is able to deduct $60,000 in year one and carry the remaining deduction of $40,000 to year two. John’s tax savings is $15,000 in year one and $10,000 in year two (assuming John’s effective income tax rate is 25 percent) – effectively increasing what Laura left for John by $25,000.
The beneficiary’s tax savings can be even higher if the beneficiary funds the precatory charitable gift with appreciated assets.
For example, William has a $4 million estate and would like to leave $500,000 to charity at his death and the remainder to his daughter, Shelby. Shelby has a taxable investment portfolio with a basis of $400,000 and a fair market value of $500,000. Shelby has a combined state and federal tax rate of 30 percent (ignoring differences in rates for ordinary income and capital gains). If Shelby liquidates the taxable investment portfolio, she will pay $30,000 in income taxes.
Option #1: William’s trust leaves $500,000 to charity and $3.5 million to Shelby. No estate tax is due because William’s estate isn’t large enough to be taxable. The charitable gift provided no estate tax or income tax benefit.
Option #2: William leaves all $4 million to Shelby with an understanding – but not the requirement – that Shelby will donate $500,000 to William’s intended charity. There is still no estate tax to pay. If Shelby uses her appreciated investment portfolio to fund the precatory charitable gift in-kind, she will get: (A) an income tax deduction of $500,000 to offset other income (assuming Shelby has sufficient income to fully-utilize the deduction, this will generate tax savings of $150,000); and (B) Shelby avoids recognizing the $100,000 of unrealized gain associated with the investment portfolio (a tax savings of $30,000). The total income tax savings to Shelby is $180,000.
There are several important issues to consider before making any changes to an estate plan:
- Any “understanding” between you and your beneficiaries will not be legally binding. If it was legally binding, your beneficiaries could not claim a charitable income tax deduction for making the gifts. This may result in your charitable wishes not being followed by your beneficiaries. For example, if dad says to daughter, “I’ve always loved dogs. I’m leaving you all the money to do whatever you want with, but I’d really love it if you would give $250,000 to the local dog shelter.” The daughter might say “Dad, I know. You have nothing to worry about!” However, as soon as dad is gone, daughter gives the money to a cat shelter, or just takes lavish vacations with the funds.
- If the beneficiary that received the precatory charitable gift instruction predeceases you, the intended charitable donation may not be made. The contingent beneficiary may not be aware of your instructions or may not be able to make the gift. For example, if the contingent beneficiary is a minor, such as a grandchild, that minor does not even have legal capacity to direct that the charitable gift be made from his or her inheritance. A relative or trusted friend could remind the beneficiary when he or she reached the age of majority, but it doesn’t guarantee the beneficiary will readily agree.
- If the beneficiary is in a bad financial situation when the inheritance is received, the inheritance may be garnished or otherwise taken from the beneficiary before the charitable gift can be made. For example, if a beneficiary receives a $100,000 gift at your death that is intended for charity and the beneficiary happens to be subject to an IRS lien at that time, the IRS will take the $100,000 and the charity will not receive its gift.
- If there is a creditor risk, but you believe the beneficiary is otherwise trustworthy, consider giving the beneficiary a lifetime power of appointment in favor of one or more charities from a trust set up for the beneficiary.
- If a beneficiary is already making significant charitable gifts and running into the adjusted gross income limitation on charitable deductions, the beneficiary will not receive any tax benefit for the charitable deduction generated by a precatory charitable gift.
- Depending on the income of the beneficiaries, the income tax savings could be negligible. For example, suppose the beneficiary is a starving artist making $25,000 per year. If he follows your request and gives away $250,000 that you wanted to go to charity, he now has a $250,000 charitable deduction. Unfortunately for him, he is limited to deducting no more than 60 percent of his adjusted gross income (potentially lower, depending on the types of gifts and recipients). The unused deduction can only be carried forward for five subsequent tax years before it expires and he isn’t paying much in taxes to begin with. Is that worth the risk that the beneficiary decides to keep the money, frustrating your charitable intent? Probably not.
- If your estate includes retirement benefits out of which charitable gifts can otherwise be made, precatory charitable gifts may not save the beneficiaries income taxes. A properly-structured estate plan can make charitable gifts directly out of retirement benefits. This is highly tax-efficient because the charity will pay no income taxes on the receipt of the retirement benefits as a tax-exempt entity. If the retirement benefits are left to non-charitable beneficiaries, the beneficiaries will recognize income and pay tax as retirement benefits are received. A deduction for a precatory charitable gift may or may not offset all the retirement benefit income that is otherwise taxable to the beneficiaries. If the deduction does not offset all the income, it would have been better to include the charitable gift directly in your estate plan.
- If you do not trust all of your beneficiaries equally, you might be hesitant to single out a particular beneficiary to handle precatory charitable gifts because of the inter-family friction it may cause. Sometimes, there are more important things than tax avoidance in estate planning! For example, imagine that parents trust one of their sons to follow through with a precatory charitable gift, but think that their other son will not. If they want to give $500,000 to charity and divide the rest among their kids equally, they could give the trustworthy son $500,000 off the top with the understanding that that son will give that $500,000 to charity. The remainder could be divided equally among all their kids. This would generate a $500,000 income tax deduction for the trustworthy son and not risk allocating precatory charitable gift funds to the unreliable son that might just keep the funds. If the unreliable son finds out that he wasn’t trusted, it could make Thanksgiving gatherings rather awkward!
- If you are in a high tax bracket and have enough that you feel comfortable giving money away during your lifetime, you can realize income tax benefits yourself prior to death. Not only will lifetime charitable gifts not be included in your estate for estate tax purposes, but it will also give you an income tax deduction during your lifetime. The gifts made during life can be leveraged through a variety of tactics, including IRA charitable rollovers. An IRA charitable rollover allows an individual who is 70 ½ or older to transfer up to $100,000 annually from an IRA to one or more charities. While you won’t receive a deduction, the amount withdrawn and sent to the charity does not show up on your income tax return either. This can be a way to make charitable gifts during life while preserving non-IRA assets for your children, which lowers their tax burden as well. Also, charitable gifts can be paired with liquidation events to maximize the use of charitable deductions during life.
The precatory charitable gifting technique is not for everyone, but when applicable, it can provide a substantial and meaningful tax savings for charitably-minded families that would otherwise receive no tax benefits from traditional charitable bequests.