From the August 2003 issue of Investment Advisor • Subscribe!

August 1, 2003

Charity and Taxes

The new tax law may very well change your clients' charitable giving strategies. Here's how

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) serves up $350 billion in tax cuts and, according to the Treasury Department, will provide 91 million taxpayers with an average $1,126 in tax relief.

The Act's highlights include lower income tax rates, a 15% cap on dividend and capital gains taxes, elimination of the "marriage penalty," and an increase in the child tax credit. Businesses also receive some relief in the form of an expanded "bonus" depreciation deduction and increased Section 179 expensing. Much has been written about these changes and how they may impact your clients' investments, but here we'll explore the implications for charitable giving.

Our research shows that affluent clients are still very much interested in transferring wealth--both to their loved ones and to the charities of their choice. Many clients prefer to make outright gifts by donating cash or appreciated property directly to charities. Others find it advantageous to make gifts by retaining an interest so that an income stream is created for themselves or other beneficiaries for a specified period of time.

As with any planning strategy, you should start by identifying a client's specific objectives in order to recommend a solution that best fits their needs. We've found that the following questions are a good starting point when it comes to charitable giving:

o Why do you want to make this gift?

o How much control over the assets do you want in the giving process?

o When do you want to gift?

o How much do you want to gift?

Assets Given Outright

The new tax laws impact a number of charitable-giving strategies. First, let's consider the charitable deduction. In short, these are itemized deductions that reduce a client's taxable income, generally dollar for dollar. Although the marginal income tax rates have decreased, your clients will still receive a tax benefit from the contribution. As in the past, if there are years when you can expect your client's taxable income to be higher, you may want to time your client's charitable contributions to coincide with those years.

The lower capital gains rate may alter the type of assets one uses to make contributions. Donating appreciated stock with a low cost basis has been an extremely popular way to make charitable contributions. In addition to avoiding the capital gains tax, a client could also receive a tax deduction on the market value of the shares. With the new tax laws, your clients still get the tax deduction but the top capital gains tax is now 15% rather than 20%. Therefore, from an after-tax standpoint, you should consider what is the best use of those assets.

By running the numbers, you may find that it makes more sense to use those assets to transfer wealth to children in a lower tax bracket. The children could then sell the stock and potentially only incur a 5% capital gains tax (assuming they are in the 10% or 15% income tax bracket) or even a zero percent tax if they wait until 2008. Keep in mind that the sunset rule kicks in at the end of 2008 and that the child has to be at least age 14 or the "kiddie tax" applies.

If it makes sense for the client to contribute appreciated securities, you need to determine which is the most advantageous stock to gift. One consideration is whether the client is looking for a steady source of income. If so, it may be best to contribute stocks that pay little or no dividends and keep those that are paying higher dividends due to the lower tax rate on dividends.

If transferring appreciated property is not an option for a client, should you consider stock that has decreased in value? Generally speaking, a direct gift of property that has decreased in value is not recommended. That's because your client's tax deduction is limited to the asset's fair market value and they can't typically claim a loss. If the property is held for investment or business purposes, it may make more sense to sell the property first and then donate the cash. In doing so, your client receives the benefit of the loss deduction and a charitable deduction for the fair market value.

Adjusting Assets Given to Trusts

Based on the reduction in long-term capital gains, dividends, and marginal income tax rates, charitable remainder trusts (CRTs) may be less attractive from a tax savings standpoint. If you have clients who already have CRTs in place, you may recommend adjusting its asset mix to maximize the benefit of the lower dividend tax rate and lower long-term capital gains rate. Remember that the person establishing a CRT continues to receive income from the assets they donate and the remainder ultimately passes on to a charity.

With the tiered tax system associated with CRTs, the income distributed from the trust is classified either as ordinary income, capital gains, or tax-exempt income. The most highly taxed income is distributed first and, once it is depleted, the next highest taxed asset is distributed, and so on. By shifting the assets in a CRT from assets that are deemed ordinary income (and taxed up to 35%) to stocks that pay a dividend, your high-net-worth client will enjoy significant tax savings due to the 15% dividend tax rate. Of course, this strategy is only appropriate for clients willing to assume the additional investment risk associated with holding stocks.

JGTRRA should not greatly affect the decision to contribute assets to a charitable lead annuity trust (CLAT). A CLAT is a tax-efficient vehicle for assets that your client wishes to pass to charity and family, assuming they don't need the income generated from those assets. A CLAT is an irrevocable trust that makes payments to charity--including family foundations--for a limited time. When the trust expires, the remaining assets go to non-charitable beneficiaries such as family members.

CLATs, like other "estate tax freeze" techniques, have received much negative attention in recent years for being an ineffective wealth transfer strategy. That's because of the low interest rate environment and the fact that the 7520 rate (the number used to calculate the value of the charity's annuity interest) is 3%. However, since JGTRRA did not address the estate tax, this type of strategy is still very useful for certain clients since they can pass on wealth to their heirs while incurring minimal or no gift tax.

One key consideration in using a CLAT is whether it is structured as a grantor trust or a non-grantor trust. With a grantor trust, your clients receive an income tax deduction in the first year of the trust for the present value of the charitable payments. They would then incur taxes on the trust income each year to "recapture" the up-front deduction. On the other hand, with a non-grantor trust, the trust itself pays taxes on income generated in the portfolio. It then receives the benefit of a charitable income tax deduction up to the value of the annual charitable payments. This deduction is not subject to the limitations that apply to your client's own charitable gifts. For example, the income generated by the trust in excess of the payout to charity is subject to income tax. However, it accrues to the benefit of one's heirs as additional trust capital. Due to the difference in income tax rate structures for individuals and trusts, and the related reductions in individual taxation, it may be more effective to use a non-grantor trust.

As we've seen, the new tax law should prompt a review of the charitable-giving strategies of your high-net-worth clients. In particular, it's more important than ever to analyze a client's assets to determine the most appropriate vehicles to use for their charitable gifting. Only by doing so can you can recommend the best approach to meet their needs.

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