1 Introduction: THE SECRET TO UNDERSTANDING PLANNED GIVING, Part Two

1 Introduction: THE SECRET TO UNDERSTANDING PLANNED GIVING, Part Two

Article posted in General on 7 July 2015| 2 comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 7 July 2015
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Summary

We continue with part 2 of the Introduction to Visual Planned Giving by contributing author Russell James III.

VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

1 INTRODUCTION:
THE SECRET TO UNDERSTANDING PLANNED GIVING, Part 2

Click here to read part one of the introduction, or follow the book links at the end of this section.

For the fundraiser, the simplest approach is to ask for money.  Getting the donor to write a check is clean and quick.  Beyond sending an appropriate gift receipt, it requires no knowledge of taxes, investments, finance, or law.  These gifts of cash are the big red “easy” button for fundraiser and donors.  So, why learn all of this planned giving stuff?  Because when fundraisers ask for cash, they are asking small.

This doesn’t mean that a fundraiser can’t ask for a big check.  It means that when the fundraiser asks for cash, regardless of the size of the request, he or she is asking for money out of the cash “bucket,” and the cash bucket is the smallest bucket.  Significant wealth is not held in cash, it is held in assets.

Only a tiny fraction of financial assets, not to mention real estate or tangible personal property, are held in a form that is accessible by simply writing a check.  Wealth is held in other forms and these forms are much less accessible.  This lack of access may come from the difficulty in easily selling all or part of the asset, from legal barriers, or from negative tax consequences resulting from a sale.  It is certainly easier for the fundraiser to ignore this less accessible wealth and simply concentrate on the 1% of financial assets that are held in cash.  Taking the easy route means that the fundraiser will always be asking from the small bucket.  Without changing this perspective, neither the fundraiser nor the donor will be focused on the possibility of those truly transformational gifts that inevitably come from non-cash assets.

A more obvious way in which planned giving can generate more charitable gifts is by addressing the barriers that prevent donors from making larger gifts.  In conversation, this is frequently phrased as, “I wish I could do more, but…”  Whatever follows this introductory line often reveals the primary barrier preventing the donor from making the desired gift.  Most commonly, these barriers to giving relate to other financial obligations.  This is where planned giving’s power to trade a gift for income becomes especially relevant.

The exact nature of the barrier to further giving will vary from donor to donor.  Often the barrier will relate to the need for income.  For example, the donor may feel pressed to save for retirement.  In such cases, a deferred Charitable Gift Annuity or Charitable Remainder Trust might be of interest.  A donor indicating the barrier of being on a fixed income may lead to the opportunity to suggest gifting assets in exchange for additional income, thus permitting a gift and addressing the financial limitation.  Of course, a fundraiser who is asking only for cash would never think to consider asking for assets, much less asking for assets in a way that generates income for the donor.  One of the most common concerns among older donors is the risk of outliving their assets.  The Charitable Gift Annuity is a solution directly intended to address this concern by trading a gift for guaranteed lifetime income.

Those with substantial wealth may also have limited cash due to the wealth being tied up in a farm or business.  Such assets may appear inaccessible to the donor, given the substantial capital gains tax that would be due at their sale.  The informed fundraiser can point out the variety of ways in which such assets can be sold without the need to pay capital gains taxes in a charitable transaction that generates income for the donor.  Even if the donor is not immediately interested in such a transaction, simply making sure that the donor knows such options are possible before the sale of the business is an important first step. 

A donor’s concern for immediate income may lead him to postpone a gift and instead consider putting a gift in his will.  Such a result is perfectly acceptable, but it may also bring up opportunities to discuss converting the gift at death from a revocable gift to an irrevocable one.  This conversion not only secures the gift for the charity, but also can generate substantial tax benefits to the donor through methods such as a remainder interest gift in a home or farm, a Charitable Remainder Trust, or even a Charitable Gift Annuity.

For the well-informed fundraiser, the magical phrase beginning with, “I wish I could do more, but…” should spark a wide range of possible solutions and suggestions.  Getting the opportunity to inform the donor about these can be as simple as asking, “What if there was a way you could do both?  Would you like to hear about that?”  This simple form of appreciative inquiry identifies when the donor might truly be interested in learning.  This also avoids the sense that the fundraiser is aggressively pushing the donor.  Instead, the fundraiser is simply serving in the role of an informed advisor, available whenever the donor so desires.

This book will review a wide variety of planned giving methods that involve transfers of assets rather than cash.  Before diving into that complexity, let’s look at a simple example of how a fundraiser can effectively shift from asking for cash to asking for assets.  This doesn’t involve trusts, annuities, foundations, or legal documents.  Yet it allows the fundraiser to start asking for assets instead of cash in a way that can generate enormous benefit to the donor.

Suppose a donor is interested in giving $100,000 cash.  (It could be any significant amount, but this is a nice even dollar figure.)  Of course, most fundraisers will respond to such a possibility by simply encouraging the cash gift and then thanking the donor.  But, for the fundraiser who understands a little bit of planned giving, this offer opens up the possibility to both benefit the donor and shift the donor’s mindset towards the concept of giving assets rather than cash.  For the itemizing donor at the top tax rate without other restrictions, the cash gift could create a federal tax benefit of 39.6% of the value of the gift – in this case, $39,600.  Suppose the donor also holds $100,000 of highly appreciated publicly traded stock.  Maybe the donor purchased 10,000 shares at $1 and they are now worth $10.  This appreciation is great for the donor, but it also carries with it a tax burden.  At the moment he sells those shares, the donor will owe a tax bill of 23.8% on every dollar of appreciation.  In other words, a sale of the shares will cost the donor 23.8% X $90,000 ($90,000 is the amount of increase in value from $10,000 to $100,000), or $21,240.  There is no way for the donor to convert this $100,000 in appreciated stock into $100,000 of cash without paying the IRS $21,240.

Now there is.  If the donor decides to give the shares of publicly traded stock to the charity and keep the $100,000 in cash, the donor ends up with $100,000 in cash and no tax liability.  The charity receives the $100,000 in shares and immediately sells them.  Because the charity is a nonprofit organization, it pays no taxes on this sale.  After the sale, the charity ends up with the same amount of cash as it would have if it had simply accepted the check.  Additionally, the donor is able to keep the $100,000 in cash he was initially going to give to the charity, thus converting the shares to cash without paying any taxes.  In this case, the donor is still able to take the full $100,000 income tax deduction for the gift of stock.  Thus, the donor gets the double benefit of a tax deduction plus avoidance of the capital gains tax.

Although the tax consequences are beneficial, it appears to require the donor to have a simultaneous desire to make a gift and to change his investment portfolio.  This is not true.  The donor can maintain precisely the same portfolio before and after the transaction.  Instead of giving $100,000 of cash, the donor gives $100,000 in appreciated stock and then immediately uses the cash to purchase $100,000 in new shares of the stock.  As a result, the donor’s investment portfolio doesn’t change, except that the new shares were purchased for $100,000 instead of $10,000.  This is a fantastic result for the donor because whenever the donor does decide to sell the shares, his capital gain (or loss) will now be based on this much higher purchase price.  If the donor decides later to sell these new shares when the price was still $100,000, he will owe no capital gains taxes.  If the donor had kept the original shares and then decided to sell them later when the price was $100,000, he would have owed $21,240 in capital gains taxes ($90,000 appreciated X 23.8%).  This “charitable swap” of gifting shares and purchasing replacement shares can be completed on the same day.  There is no rule requiring waiting as with the “wash sale” rule, because these shares are appreciated.  The “wash sale” rule applies only to shares that have gone down in value.  The “wash sale” rule should never be a concern in a charitable transaction because depreciated investments should never be given to charity.  Instead, they should be sold in order to get the tax benefit of the loss.  After the sale, then the proceeds from the sale can be donated if desired.

Some fundraisers may react to this highly beneficial transaction with indifference.  If the fundraiser’s job is simply to ask for cash, then alerting donors to these hidden tax benefits is just not in their job description.  From this perspective, the donor’s financial welfare is of no concern to the fundraiser.  This cavalier attitude of intentional incompetence is not only bad for the donor; it is also bad for the nonprofit.  A fundraiser who wants to encourage large, transformational gifts must shift the donor’s perspective from giving cash (“giving from the little bucket”) to giving assets (“giving from the big bucket”).  On the surface, it may not seem like a tremendous win for the charity to convert a $100,000 cash gift into a $100,000 stock gift.  Psychologically, it is a great achievement.  Now, whenever the donor prepares to sell a highly appreciated asset, this special tax benefit may arise in his mind.  Gifting is no longer associated just with spare cash, but now comes to mind whenever assets are moved.  Understanding the tax benefits of gifting, rather than selling, appreciated assets opens up the entire world of sophisticated planned giving.  This same technique will be employed repeatedly in various transactions involving Charitable Remainder Trusts and Charitable Gift Annuities where the donor not only avoids the capital gains tax but also receives income based on the full, untaxed amount of the gifted asset.  This world of opportunity starts with an important shift in the donor’s mindset from giving cash to giving assets.

What about the donor who wants to give to a very small charity that doesn’t accept shares of stock?  Is this great tax advantage impossible?  No.  Even if the charity doesn’t know how to deal with gifts of stock, the donor can complete this transaction using a donor advised fund.  The donor gifts the shares to a donor advised fund such as those operated by various financial institutions (Fidelity, Vanguard, and Schwab).  This transfer to a donor advised fund creates an immediate income tax deduction.  The donor then directs the donor advised fund to sell the shares and write a check to the charity.  The charity receives only the cash and never has to deal with the securities, but the donor still receives the tax benefit.  The rest of the transaction can occur as before with the donor using the cash he would have gifted to the charity to purchase replacement shares of the stock.

To this point, we have been looking at planned giving from the perspective of the fundraiser and the nonprofit organization.  However, planned giving can be useful not just for fundraisers, but also for financial advisors.  Some financial advisors may sell life insurance products in which case the variety of transactions involving life insurance, discussed in later chapters, will be of direct interest.  Even for those financial advisors who are compensated solely as a percentage of assets under management, understanding charitable planning can be an important proficiency.  Well informed financial advisors can become more attractive to clients with significant charitable interests by providing dramatic planning benefits.  Such clients are often those with substantial wealth, making them particularly attractive for the financial advisor.  Additionally, a variety of charitable planning techniques, such as Charitable Remainder Trusts, private foundations, and donor advised funds, allow advisors to continue to manage the funds within the charitable instrument, sometimes for multiple generations.  In many cases, these funds are undiminished by the otherwise common effects of capital gains taxes, income taxes on earnings, estate taxes and division among heirs, resulting in greater assets under management.

Charitable planning expertise can be particularly useful for financial advisors who wish to work with wealthier clients.  As wealth increases, the tendency to engage in charitable planning also increases.  Thus, this body of knowledge is particularly useful in attracting and benefitting the higher wealth clients that are so often sought after by financial advisors.  A financial advisor might use this knowledge as a means of marketing his or her services.  This can be done formally through the offering of seminars, perhaps to the significant donors or board members of a local charity.  It can also be done informally through conversations.  Simply learning that a person has made a significant gift (often easily identified by various donor recognition levels) can lead to a conversation over whether the gift was of cash or appreciated securities and an explanation of the relative benefits of gifting appreciated securities through the “charitable swap” technique.  Providing such value to prospective clients can be a good first step to establishing a relationship as an advisor.

Helping clients to take advantage of the tax benefits available through charitable planning can benefit financial advisors not only by demonstrating the value of their advice to clients, but also by increasing the client’s assets under management.  Take the example of a client who holds a highly appreciated asset that generates little or no income.  Such occurrences are quite frequent as those who build significant wealth often do so by owning relatively illiquid businesses or properties.  At some point, the client may wish to convert this non-income producing asset to an income-generating asset.  The standard approach to such a conversion is to simply sell the asset and use the proceeds to purchase another asset that generates more income.  However, if the client already has interest in leaving a charitable gift at death, this may not be the best approach.  Instead of selling the asset and paying the resulting capital gains taxes, the client could transfer the asset to a Charitable Remainder Trust, allow the trust to sell the asset, and then receive income for life from the trust with the remainder going to a charity at death.  This charitable approach not only avoids the capital gain taxes (the Charitable Remainder Trust is a charitable entity and thus pays no taxes upon the sale of the appreciated asset), but also generates an immediate income tax deduction.  Such dual tax benefits can significantly increase the amount of funds available to be managed by the financial advisor.  During the client’s life, the financial advisor can manage the funds in the Charitable Remainder Trust, including those as assets under management subject to the advisor’s normal management fees.  Further, the charitable recipient at the client’s death could be the client’s own private family foundation, with assets also managed by the same advisor.

Taking the example of a $1,000,000 asset with no basis, the traditional “sell and reinvest” strategy would net $722,000 in the typical state with a roughly 5% state capital gains net tax.  (The calculation is a little more complex than that shown here due to the federal income tax deduction for payment of state taxes.)  In a higher taxation state such as California, such a sale may result in only $660,654 left to invest ($1,000,000 gain subject to 13.3% top rate in California and 23.8% top federal rate where state taxes are deductible).  Contrast this with the Charitable Remainder Trust where the entire $1,000,000 remains after the sale, available to be invested and managed by the financial advisor.  Additionally, such a transaction will generate an income tax deduction of at least $100,000, increasing the assets under management outside of the Charitable Remainder Trust by reducing tax payments.  Depending upon the state income tax rates, this tax deduction may be worth $45,000 or more.  Thus, charitable planning results in assets under management of $1,045,000 or more instead of only $722,000 or even $660,654.  Clearly, this is no small difference for the client and the advisor.

In addition to the increase in assets under management resulting from avoidance of capital gains taxes and generation of income tax benefits, charitable planning can also increase assets under management by providing for tax-free growth environments.  Over time, investments that grow without taxation will accumulate much more rapidly than their regularly taxed counterparts, leading to greater assets under management.  A simple version of such tax-free growth is available with a donor advised fund.  Money transferred to a donor advised fund must eventually be given to a charity – although at present there are no time restrictions on when this would occur.  In the meantime, the financial advisor can take fees for managing the funds and the funds can grow without taxation because the account is a charitable account.  Similarly, Charitable Remainder Trusts pay no taxes on investment income.  Like a traditional IRA, taxation occurs only when funds are removed from Charitable Remainder Trust.  Assets within a private foundation do not grow entirely tax free, but the tax rate is only 1% or 2%, making them almost tax free.

Creating multi-generational charitable entities, such as private foundations, can also increase the length of time that a particular financial advising firm will be able to manage the funds.  In the typical estate scenario, the death of the client results in the loss of all assets under management.  First, the wealth is reduced through estate taxation and then it is divided into smaller pools corresponding with the number of heirs.  This creates a situation where the advisor either cannot or would prefer not to continue as the asset manager.  Continuing to manage the assets would require having relationships with each of the heirs stronger than those of their other potential financial advisors.  Even if such connections were possible, the advisor is faced with managing more relationships for smaller pools of money.  At a minimum, the time commitment and hassle for the financial advisor is significantly multiplied.  Realistically, the funds will likely leave the advisor’s management upon the death of the client.

However, if the client had established – during life and through estate planning – a multi-generational charitable entity, the advisor is in a much stronger position.  The charitable pool of funds is undiminished by either estate taxation or division among heirs.  The advisor’s existing role as charitable asset manager places him or her in a strong position to continue in that role after the death of the client.  Rather than having to be the top choice for each individual heir, the advisor need only be acceptable to the majority of those appointed by the deceased client.  Further, managing charitable funds is often much easier than managing personal accounts.  Losses to the charitable entity tend to be less personally distressing than losses from one’s own investments.  Such a dispassionate management scenario often reduces the amount of personal coaching and “hand-holding” necessary during inevitable market fluctuations, making the asset management that much easier for the financial advisor.

This book will explore a wide variety of charitable planning techniques.  The tax and financial consequences of many of these techniques can become quite complex.  There is no need to despair in the face of such seemingly unending minutia.  Instead, remember the simple secrets to planned giving.  Planned giving can do two things, reduce taxes and trade a gift for income.  Fundraisers should use it for two main reasons, to ask from the big bucket of assets, rather than the small bucket of cash, and to work with donors who say the magic phrase, “I wish I could do more, but…” Financial advisors should use it for two different main reasons, to provide dramatic benefit to highly desirable clients, and to increase multi-generational assets under management.

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