The era of personal responsibility has dawned upon us. For those questioning this sweeping statement, consider the demise of defined benefit plans, threats posed to the long-term survival of our Social Security system and the financial challenges presented by an increasingly fluid job market. Conventional notions of job security and retirement safety nets are quickly vanishing.
Counterbalancing these powerful forces has been the rise of the 401(k), health savings accounts (HSAs) and an increasingly prosperous population. Although the role played by traditional financial safeguards has diminished, more individuals are enjoying wealth now than at any other time in our nation’s history. This amalgamation has produced affluent Americans who have taken the initiative to secure their own financial well-being.
The demographic of wealthy Americans that has garnered the most attention are the owners and executives of the small- to medium-size business market. Of the 9.5 million business owners in the U.S., 26% are now considered affluent. Within the context of charitable giving, this statistic is important because these individuals are predisposed to be philanthropic.
A Bank of America study on high net-worth philanthropy, released in October, found a strong correlation between entrepreneurship and charitable giving. Specifically, high-net-worth households with 50% or more of their net worth coming from entrepreneurship contributed to charity, on average, $232,206. In contrast, households with 50% of their net worth coming from appreciated real estate contributed on average $11,015. (See chart.)
Owners and executives are seeking sound advice regarding ways to combine their charitable motivation with personal business planning. Unfortunately, in the race to provide comprehensive financial planning for owners, the industry has fallen short in capitalizing on the altruistic motives of this demographic.
Until recently, the Internal Revenue Code has not made this an easy task. A C corporation may only deduct charitable contributions to the extent of 10% of taxable income (I.R.C. 170(b)(2)). Alternatively, individuals can contribute up to 50% of adjusted gross income. Fortunately, this provision is inapplicable to the vast majority of entities that compute their taxable income in the same manner as an individual: S corporations, partnerships and limited liability companies.
This inequity towards business owners has been further exacerbated by other unfavorable tax regulations. For instance, until a short time ago, if an S corporation made a charitable contribution of appreciated property, the shareholder’s basis would be directly reduced by his or her share of the fair market value of the property.
The recently enacted Pension Protection Act (PPA) amended this harsh tax treatment for tax years beginning in 2006 and 2007. Under this rule, a charitable contribution of property will reduce a shareholder’s basis in stock in an amount equal to the pro rata share of contributed property rather than the respective share of the fair market value. For instance, a 100% owner of an S corporation contributing stock valued at $1,000 with a basis of $200 will be treated as having made a contribution of $1,000 but will only have to reduce basis by $200.
A new PPA provision regarding IRA distributions to charity also provides a measure of relief to affluent business owners. Under the new law, in effect until December 2007, a taxpayer who has reached the age of 70 1/2 may distribute up to $100,000 to a public charity and exclude the amount of that distribution from gross income for federal income tax purposes. While an income tax deduction is not allowed, the distribution will count towards the taxpayer’s required minimum distribution.
There exists a plethora of opportunities for business owners already contained in the tax code that are not the product of recent legislative grace.
Consider the case of Peter West, a budding philanthropist and 70-year old owner of a successful limited liability company that transacts real estate. He is troubled by his exposure to high income taxes because all income earned by the business passes through to his personal 1040.
Peter has unsuccessfully sought to reduce his taxable income but is restrained by limits on qualified plan and fringe benefit deductions. He is also unable to delay taxation through a nonqualified deferred compensation arrangement. He has 5 children, but only 2 are interested in taking over the family business. As the bulk of his personal estate is wrapped up in the LLC, Peter questions how he will “equalize” his estate to the other 3 children while avoiding the devastating impact of transfer taxes.
Peter decides to transfer $1 million of his real estate to a charitable remainder annuity trust (CRAT) and take back 5% annuity interest over his lifetime. Using a discount rate of 6%, he obtains a $575,000 income tax deduction that he can carry forward an additional 5 years to offset his taxable income.
Peter has secured a $50,000 annual lifetime income while removing this property from his estate, free of income and transfer taxes. Finally, he can use all or a portion of this income (subject to a 4-tier system of taxation) to fund a life insurance policy held in an irrevocable life insurance trust (ILIT). This trust, known in the industry as a wealth replacement trust, can equalize the estate and replace tax-free wealth to Peter’s children not involved in the business.
Consider the case of Patti and Dean Henderson, co-owners of a successful S corporation seeking ways to combine their charitable intentions with income tax planning. They’re uncomfortable parting with any of their disposable assets but find they no longer need a $2 million life insurance policy. Their decision to donate the policy outright to a public charity benefits not only the charity but may garner a sizable income tax deduction.
In this scenario, the donors have paid premiums of $10,000 for 25 years. Thus, the donors’ basis in the policy is $250,000 (25 x $10,000 annual premium). The transfer of a life insurance policy to charity in most cases will not trigger any income tax liability. The donors are entitled to a charitable deduction of $250,000, since it is less than the $400,000 value of the policy. The $250,000 deduction will be subject to the 50% AGI limitation (not the 30% limitation) because there is no capital gain element involved in the charitable deduction. If their adjusted gross income is insufficient, the excess is carried over and may be deducted up to 5 succeeding years.
Business owners and executives represent an emerging class of philanthropic individuals who have largely been ignored by the financial services industry. Fortunately, they also represent a prime opportunity for advisors who recognize new and innovative ways to combine their own business planning expertise with the charitable tendencies of these entrepreneurs.