Charitable deductions under scrutiny – and giving techniques that Congress ignores
Congress continues to examine itemized deductions on the income tax return, evaluating ways to minimize their use. Although charitable giving has remained relatively unscathed, this could change due to a number of proposals now under consideration. Intriguingly, the future of tax-wise giving may be found in other parts of the income tax return.
On May 24, 2011, the Congressional Budget Office released its report entitled "Options for Changing the Tax Treatment of Charitable Giving." The 11 options it examined were grouped into four categories:
- Deductions for itemizers, with a floor
- Deductions for all taxpayers, with or without a floor
- Nonrefundable 25 percent credit for all taxpayers, with or without a floor
- Nonrefundable 15 percent credit for all taxpayers, with or without a floor
Congress may not implement a decrease in the "government subsidy" of charitable giving in the immediate future, but that is not the point. If we look at the historical trend toward reducing itemized deductions overall, it is clear that Congress has its eye on the budgetary impact of Schedule A.
Regardless of these changes, significant charitable benefits are available from places on the tax return not under the Congressional microscope. But it requires a different focus.
Let me suggest that we have traditionally fixated on the wrong line of the tax return, "Taxable income." Instead, we should focus our attention on "Adjusted gross income," line 37.
For many taxpayers, arriving at taxable income is only the first step in the tax calculation process. They may then go through a separate calculation process to determine such things as the applicability of the alternative minimum tax or taxation of Social Security benefits. The starting point for those recalculations is adjusted gross income. From that number, previously excluded items, including tax-exempt interest and previously itemized deductions, may be added back to compute final tax liability. Thus, for purposes of subsequent calculations, our goal is to keep the AGI as low as possible.
There are at least three ways in which charitable giving can reduce AGI for all calculation purposes. These are achieved by reducing the income lines on the 1040.
1. Line 13, Capital Gain or Loss. Most people know that the direct gift of a long-term appreciated asset prior to its sale will avoid capital gains and result in a tax deduction. For our purposes, this gift may also leverage the ability to capture a capital loss.
Example. Bob is planning on liquidating stock. He will have an aggregate capital gain of $6,000 from some assets, and a $6,000 loss from others. The sales would offset each other, resulting in an entry of zero on line 13. We know that one may deduct the excess of capital losses over gains to the extent of $3,000 per year. So Bob gives stock with a $3,000 gain to charity. The impact on line 13? He will show a $3,000 loss, thereby reducing his adjusted gross income.
2. Line 15a, IRA distributions. As a general rule, direct lifetime charitable gifts from IRAs must be declared as income first before a deduction is taken. Through the end of 2011, Congress has extended an exception to this rule for individuals who are over the age of 70½. They may make direct gifts to charity of up to $100,000 this year, without showing the distribution as income. Since they are not showing the income, no charitable deduction is available. For individuals who do not itemize their deductions, this option is particularly attractive.
Example. Bob is over age 70½ and this year must take a required minimum distribution from his IRAs of $10,000. During 2011 he may make a direct distribution from his IRA to charity. If he does so, the $10,000 he would be required to show as income is eliminated.
3. Line 8b, tax-exempt interest. People often confuse tax-exempt with tax-free. Tax-exempt interest, such as from municipal bonds, is not included in gross income the first time through the tax return. It may be added in later for other purposes, such as determining the taxability of Social Security benefits. Tax-free income never appears on the tax return.
One manner of converting tax-exempt income to tax-free income is through the use of a charitable gift annuity. Gift annuity payments are broken down into two components: taxable and tax-free. The taxable portion shows up on line 8a; the tax-free portion never appears on the return.
Example. On July 1, 2011, Bob, age 75, takes out a $10,000 charitable gift annuity with the Jewish Home. In the year of the gift he is entitled to a charitable deduction of $4,162.30. His annual lifetime annuity is $650 (6.5 percent), of which $179.40 is reported as ordinary income. The sum of $470.60 is tax-free, since it is considered to be return of principal. Thus, unlike tax-exempt interest, the $470.60 portion of the annuity will not be includable for any tax purposes.
A further discussion of charitable gift annuities and some benefits that are time-sensitive is the subject of the other article in this newsletter.
Utilizing the income portion of the tax return for charitable giving is not for everyone, of course. But for clients who are concerned with their multi-year tax liability, reviewing these options may benefit them well into the future.
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Dear Colleague,
