By Sarah H.B. Kahl, Esq.
In the past few years, the United States has experienced one of its most challenging economic downturns. Charities have found themselves among the hardest hit. Yet new legislation and low interest rates mean that charities can take advantage of highly favorable tax strategies for donors. By staying ahead of tax law changes and educating their donors about tax saving techniques, charities can create a win-win scenario for the donor and the charity. Here are four potential donor tax strategies charitable organizations might consider to help enhance fundraising efforts in 2011.
Encourage Donors To Take Advantage of Low Interest Rates
Certain charitable giving techniques take advantage of low interest rates. Each month, the IRS publishes an interest rate (known as the Section 7520 rate), which is the rate used for a number of charitable planning techniques. The Section 7520 rate was extremely low at the end of 2010, and although it is rising fast, the rate is still low by historical standards. The rate for February is 2.8%. By comparison, the Section 7520 rate for February of 2007 was 5.6%. In addition, for many charitable techniques, the lowest rate from the current and prior two months may be selected, which helps when the interest rate is climbing. For example, February transactions could take advantage of December’s 1.8% rate.
One technique that is more attractive to donors when interest rates are low is the charitable lead trust (CLT). The mechanics of a CLT provide that a charity receives an interest for a period of years. The interest could be expressed either as a dollar amount or as a percentage of the assets held in the trust. At the remainder of the term, whatever amount was left in trust would pass to the specified individuals. Depending on the structure of the CLT, the donor may receive an income tax deduction, and significantly, the individual donee receives the remainder interest at little or no gift tax cost to the donor.
The CLT is thus primarily a gift and estate tax planning tool. This tool is therefore generally used by the very wealthy because only the very wealthy will have gifts or estates that will incur federal transfer tax under current law. The tax compromise legislation passed at the end of 2010 allows $5,000,000 per person, $10,000,000 per married couple, to pass to heirs free of those taxes through 2012. Although there is no guarantee that the $5,000,000 exemption will be permanent, and there are still state estate taxes to consider, that amount of wealth serves as a basic threshold for those who should be considering estate planning techniques like the CLT.
Consider a hypothetical donor who might contemplate this technique, particularly when interest rates are low. A mother with a potential $20,000,000 estate is interested in setting up a trust fund for her adult children. Her stock portfolio is down, but she anticipates that it will grow over time. She is also interested in benefiting her favorite charity, to which she typically makes annual gifts, but her primary goal is giving as much to her children as possible without incurring gift tax. The mother could transfer $1.0 million of her stock to a CLT that would pay her favorite charity $110,170 each year for 10 years. Even if the stocks contributed grew as little as 5% annually, there would still be $243,188 left at the end of the term for her children. An 8% return would provide $562,940 for her children.
If the mother had made the same transfer, for example, in February 2007 when interest rates were higher, the amount that would be required for the charity would be $133,310, and 5% growth would have left nothing for her grandchildren. From the perspective of a donor like the mother, a low Section 7520 rate makes a CLT look more attractive.
From a charity’s perspective, it is true that low interest rates will decrease the amount required to be distributed to the charity each year by a relatively small amount. The attractiveness of the technique to donors, however, means that charities may be able to encourage more wealthy donors to take advantage of it.
Draw on Demand for Fixed Income by Offering Charitable Gift Annuities
In difficult economic times, a donor may find security in receiving a fixed payment for life. A charitable gift annuity may be the answer to a donor interested in benefiting a favorite charity while receiving such a payment. The donor may find the gift annuity to be more favorable than a charitable remainder trust because the charity’s assets, not just the amount donated, are on the hook for payment.
In a charitable gift annuity, a donor contributes property to a charity (typically appreciated property) in exchange for an annuity payment for the remainder of the donor’s lifetime. The annuity would be lower than fair market value, and the difference is the gift element to the charity.
Although donors may find this arrangement more favorable in difficult economic times, charities should take particular care to ensure compliance with regulatory and tax rules regarding charitable gift annuities. For example, in order for the charity to avoid unrelated business income tax, the gift portion of the annuity must have a value of at least 10% of the value of the property. This is more difficult to achieve when interest rates are low. Nevertheless, with careful planning, a charity may find that a charitable gift annuity is a valuable tool for attracting donors.
Stay Ahead of the Charitable Rollover Rules
The new legislation at the end of 2010 extended the time available for making a tax-free direct distribution from an IRA to a charity. The law as originally enacted under the Pension Protection Act of 2006 only provided this ability to donors making such distributions in 2006 and 2007, which was later extended to 2008 and 2009 by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. The recent legislation now allows the same treatment for 2010 and 2011.
During this time, an individual over age 70½ can exclude from gross income a distribution up to $100,000 made directly from an IRA to a qualified charity. Qualified charities do not include private foundations or donor-advised funds.
At first glance, this provision does not seem particularly favorable, as donors may simply withdraw from an IRA, include the withdrawal in gross income, make a charitable contribution with the funds, and receive a charitable deduction. However, there are a number of hidden rules in the tax code that make this treatment less favorable. In some cases, a donor is limited in the amount of deduction that can be taken, and in others increased gross income results in other negative tax effects.
This new law may appeal to donors who are over age 70½ who have significant IRAs. Because there is no guarantee that this law will be extended again, this is a good time to encourage these donors to make charitable gifts using their IRAs in compliance with these rules.
Offset Roth IRA Conversion Income
When the law changed beginning in 2010 allowing anyone, regardless of adjusted gross income, to convert a traditional IRA to a Roth IRA, many people took advantage of the new ability to convert. Those individuals realized a large amount of taxable income on conversion. This income could be spread over two years, so many of those who converted in 2010 also have large amounts of taxable income expected for the 2011 tax year. Donors could be reminded that a charitable donation is an excellent way to offset taxable income.
Basic charitable donations can allow deductions, but charitable lead trusts, discussed above, depending on how they are structured, can also offer a significant upfront deduction that could be used to offset taxable income from either a 2010 conversion or a 2011 conversion. Charities may wish to partner with investment firms to help donors calculate the potential wealth savings on Roth conversion coupled with a charitable gift.
Charitable organizations can use the foregoing strategies to help enhance their fundraising efforts despite the challenges presented by the financial crisis. Consider expanding or enriching your organization’s fundraising efforts by educating your donors about CLTs, charitable gift annuities, charitable rollovers, and offsetting Roth conversion income.
Sarah H.B. Kahl, Esq. is an associate in Venable LLP’s Tax and Wealth Planning Group. She can be reached at 410-244-7584 or sbkahl@venable.com. This article is not intended to provide legal advice or opinion and should not be relied on as such. Legal advice can only be provided in response to specific fact situations.