Charitable Giving for Entrepreneurs after TCJA Brian T. Whitlock, CPA, JD, LLM THE GLOBAL FOODBANKING NETWORK
Agenda Overview of charitable giving pre-tcja Review TCJA Changes Impacting Charitable Giving The Typical Entrepreneur, their assets, and goals What to Give? How to Give?
2016 US Trust Philanthropy Study Charitable giving totaled $390 Billion in 2016 72% of charitable giving came from individuals 59% of the general population (avg. $2,500 year) 91% of High Net Worth Individuals (avg. $25,000) Definition of High Net Worth Individual $1 million of assets or $200 K of household income
Charitable Giving by Generational Group Generational group Year of Birth Percentage of US population Percentage of charitable giving Millennials 1981-1997 30.4% 5.4% Gen X 1965 1980 26.6% 15.7% Baby Boomers 1946 1964 30.2% 41.6% Silent Generation 1928 1945 11.3% 30.5% Greatest Generation 1900 1927 1.5% 6.7% Total 100.0% 100.0% Blackbaud Institute, February 2017 Individuals over age 54 account for over 80% of total giving
Individual Tax Rates (2018-2025)
Married Individuals Filing Joint Returns (and Surviving Spouses)
Contribution Changes for Individuals IRC 170 (b) Limit increased from 50% to 60% for cash No 80% deduction for right to purchase athletic tickets Exception to contemporaneous written acknowledgement requirement is repealed (must be obtained now for any contribution of $250 or more) can No longer point to Form 990 Schedule B Standard Deduction increases to $12,000 for Single taxpayers ($18,000 for Head of Household; $24,000 for MJF; $26,600 for MFJ both over age 65).
TCJA Impact on Trusts Trusts in top income tax bracket (37%) over $12,500 NOTE: Complex Trusts are permitted to claim charitable contribution deduction against gross income under IRC 642(c), not subject to AGI limitation, but only if the original trust agreement specifically empowers the trustee to make charitable gifts from income. In IRS Chief Counsel Memo 200140080 service acknowledge several cases at permit trusts to deduct contributions made by flow-through entities (partnerships and S Corporations) as being deemed made pursuant to the terms of the governing instrument. Complex trusts are permitted a distribution deduction (DNI) for amount distributed to beneficiaries.
Contribution Changes Impacting Businesses S Corporation - ESBT (after 2017) Deduction for charitable contributions will be determined using rules applicable to individuals (not trusts) AGI Percentage limitation Carry forward provisions
Entrepreneurs and their Assets Business Assets (usually the largest part of net worth) Closely Held Business Interests C Corporation S Corporation Partnerships and LLC Rental Real Estate Patents and Copyrights Non-Business Assets Retirement Assets Home Life Insurance Marketable Securities Cash (usually the smallest part of net worth)
Whose your Donor? Individual or entity Businesses that operate as Flow Through Entities (S Corporations, LLCs, and Partnerships) can all donate directly to charity. The assets need not be distributed to the individual first. Each of the Donations fall under the limitations applicable to individuals. A donation by an S Corporation of an appreciated asset will only reduce AAA and the S Corporation Stock Basis by the basis of the asset that is distributed yet the individual may receive a deduction based upon FMV if the asset is given to a public charity.
Entrepreneurs and their Motivations A donor's motivation and expectations of benefits may be examined if the government believes that the contribution is only motivated by a substantial benefit in return. In Singer v. U.S., 449 F2nd 413 (1970) the Federal Court of Claims held that granting a 45% discount on the sale of sewing machines to schools was not a contribution or gift, because the seller expected the transaction to eventually result in increased sales. Even though a direct benefit from the donee and the absence of an enforceable contract right to a return benefit was not required, the court believed that the hope for a future business advantage was a sufficient expectation of benefit to deprive the donor of a deduction. In Ottawa Silica Co. v U.S., 699 F2d 1124 (1983) the Federal District Court disallowed a deduction for the value of land donated to a governmental unit as a site for a new school. The court found that the donor had reason to believe that construction of a school would cause the construction of new roads that would in turn increase the value of the donor's retained land, even though there was no agreement or other requirement that the roads or the school would be built. Nevertheless, the court held that there could be no deduction when the donor receives, or anticipates receiving, a substantial benefit in return. A similar result was reached in Elrod v. Commissioner, 87 TC 1046 (1986) in which the transfer of land for a highway was held not to be deductible. The Tax Court reasoned that the generosity was motivated by an expectation that the development potential of the donor's retained land would increase.
What are the best assets to give to Charity? Cash Easy but inefficient (likely post tax income) Pre-tax income Qualified Plan assets (direct distribution after 70 ½) Charitable contributions from Complex Trusts Passive Income Patents and Copyrights Appreciated Assets (with unrealized gains) Marketable Securities Real Estate (passive income) The Entrepreneur's Dilemma: Long on closely held stock short on cash and easy assets
Deduction Limitations for Public Charities* Type of Property Contributed Amount Deductible Percentage of AGI Limitation Cash Cost 60% Ordinary Income Property (inventory) Cost 50% Appreciated Capital Assets (STCG) Cost 50% Appreciated Capital Assets (LTCG) Fair Market Value 30% LTCG, with election to use cost Cost 50% Tangible Personal Property (LTCG) Related Use Tangible Personal Property (LTCG) Unrelated Use Fair Market Value 30% Cost 50% *Includes Community Foundations, Donor Advised Funds, and limited other organizations
Deduction Limitations for Private Foundations Type of Property Contributed Amount Deductible Percentage of AGI Limitation Cash Cost 30% Ordinary Income Property (inventory) Cost 30% Appreciated Capital Assets (STCG) Cost 30% Appreciated Capital Assets (LTCG) Cost 20% LTCG (qualified appreciated stock marketable securities) Fair Market Value 20% Tangible Personal Property Cost 30%
Entrepreneurs and their Assets Ranking Assets for Gifting Business Assets (usually the largest part of net worth) Closely Held Business Interests FMV only if to Public Charity equivalent Control issues(?) Rental Real Estate FMV only if to Public Charity equivalent Problematic next! Patents and Copyrights Lesser of FMV or Cost, but pre-tax Income (royalty) not UBI Non-Business Assets Retirement Assets (Pre-Tax Income and IRD) Home (Consider gift of a charitable remainder) Life Insurance (better to leave to family tax-free) Marketable Securities (better to leave to family stepped up) Cash (usually the smallest part of net worth) (Better to family)
Charitable Gifts of Real Estate FMV of Real Estate deductible for gifts to Public Charity* Full value is reduced by Mortgage debt Reduced by ordinary depreciation recapture Bargain Sale part gift, part sale Deduction of difference between FMV and Purchase Price Received Charitable Gift Annuity Funded with Real Estate Full value is reduced by Mortgage debt Reduced by ordinary depreciation recapture No Deduction for Partial Interest in Real Estate Exceptions: Charitable Remainder Trust or Pooled Income Fund Income Interest in Charitable Lead Trust Remainder Interest in a personal residence or farm Qualified Conservation Interest
Bargain Sale Treatment for Gifts of Appreciated Property for Gift Annuity If the donor contributes appreciated property for the charitable gift annuity, the transaction is treated as a bargain sale for income tax purposes. Treasury Regulation Section 1.1011-2(a)(4). The gain is prorated between the investment in the contract (value of the annuity) and the value of the gift to the charity. The gain on the gift portion is not recognized and is never taxed. If the donor is the only annuitant, and the charitable gift annuity is nonassignable, the gain will be recognized ratably over his/her life expectancy. Otherwise, the entire gain must be recognized in the year the contract is entered into. The same income tax tables used to determine the expected return multiple for annuities are used in calculating the gain to report. Treasury Regulation Section 1.1011-2(c) example 8.
Charitable Lead Trust Grantor (Donor) Step 1: Transfer assets to CLT Charity (Donee) Step 2: Income stream paid to Charity CLT Irrevocable Trust Term of Years or Life Estate and Gift Tax Benefit FMV of the transferred assets - Value Income Stream (Charitable component) = Reminder (Taxable gift of a future interest 1) Return to Grantor 2) Return to Spouse 3) Outright Family 4) In Trust for next generation
Grantor Type Charitable Lead Trust (CLAT) CHARITY GIFT TAX IMPACT FMV OF THE TRANSFERRED ASSETS - PV OF ANNUITY INCOME STREAM = GIFT OF A FUTURE INTEREST STEP 1: Gift assets to trust STEP 2: Distribute required amounts to charity CLAT IRREVOCABLE TRUST NET INCOME AND CAPITAL GAINS ARE TAXABLE TO GRANTOR PV OF REMAINDER INTEREST IS A GIFT OF A FUTURE INTEREST AND MAY USE GIFT/ESTATE TAX CREDIT CAVEAT: GST MAY NOT BE ALLOCATED TO GIFT OF REMAINDER INCOME TAX DEDUCTION DONOR MAY DEDUCT THE PV OF THE INCOME STREAM ON HIS SCHEDULE A OF HIS IRS FORM 1040 IN YEAR 1 INCOME TAX IMPACT ALL INCOME WILL THROUGH DONOR S IRS FORM 1040 EVERY YEAR UNTIL TERMINATION STEP 3: Upon termination, the remainder beneficiaries receive the balance of assets REMAINDER BENEFICIARIES (OUTRIGHT OR IN TRUST) IF REMAINDER BENEFICIARY IS PERSON OTHER THAN THE DONOR THEN GIFT
Non-Grantor Type Charitable Lead Trust (CLAT) CHARITY GIFT TAX IMPACT FMV OF THE TRANSFERRED ASSETS - PV OF ANNUITY INCOME STREAM = GIFT OF A FUTURE INTEREST STEP 1: Gift assets to trust STEP 2: Distribute required amounts to charity CLAT IRREVOCABLE TRUST NET INCOME AND CAPITAL GAINS ARE TAXABLE TO TRUST, BUT TRUST GETS DEDUCTION FOR CURRENT CHARITABLE DISTRIBUTION PV OF REMAINDER INTEREST IS A GIFT OF A FUTURE INTEREST MAY USE GIFT/ESTATE TAX CREDIT CAVEAT: GST MAY NOT BE ALLOCATED TO GIFT OF REMAINDER INCOME TAX DEDUCTION NONE INCOME TAX IMPACT INCOME IS EXCLUDED FROM DONOR IRS FORM 1040 AND STATE INCOME TAX STEP 3: Upon termination, the remainder beneficiaries receive the balance of assets REMAINDER BENEFICIARIES (OUTRIGHT OR IN TRUST) IF REMAINDER BENEFICIARY IS PERSON OTHER THAN THE DONOR THEN GIFT
Entrepreneurs and their Motivations Entrepreneur with a spouse or significant other? First Priority, spouse; charity is secondary Entrepreneur with Children (or other Descendants)? Charity begins at home Entrepreneur without Children or Grandchildren? Long-term Employees may be object of affection and concern Larger Charitable gifts are much more likely
Case Study Ernie the Entrepreneur Ernie is currently 70 years old. Unmarried. No children. Ernie owns a manufacturing and distribution business in the Chicago Suburbs. Business operates as an S Corporation. The business is worth north of $50 million and occupies real estate that Ernie owns outside of the business. Ernie has several patents related to the business. Ernie has no interest in retiring or selling the business and wants to be carried out of the business feet first. The business has four top managers who have been very loyal to Ernie and would like to retain them and reward them for their loyalty and pass the business to them. Ernie s nonbusiness assets are limited to a modest condominium, and about $2 million marketable securities and cash. Ernie is content to allow business to pass to charitable purposes after his/her death. He is not religious and only gives small amounts to charity currently.
Case Study Ernie the Entrepreneur Sale to Employees? Employee Stock Ownership Plan? Donor Advised Fund or Community Foundation Is there a need to monetize the business? Private Foundation?
Donor Advised Funds, Community Foundations, and Private Foundations If we monetize the value of the business, DAFs and Community Foundations are treated like public charities for the purposes of the AGI limitations. They are in a better position to receive illiquid assets such as an interest in a closely held business. They can avoid the self-dealing issues and permit the business to redeem the interest and monetize some or all of the investment. They must avoid potential excise tax provisions: 4966 Taxable Distributions 4967 Prohibited Benefit to family members Private Foundations are frequently considered by entrepreneurs as a method for preserving the business, without monetizing during their lifetime. However, several excise tax provisions remain hurdles: 4941 Self Dealing 4943 Excess Business Holdings 4944 Jeopardizing Investments 4958 Excess Benefit Transactions As a result, Private Foundations generally are not a good place for voting stock.
Newman s Own Exception to Private Foundations and Excess Business Holdings The Bipartisan Budget Act of 2018 was quietly enacted and signed into law on February 9, 2018. The act contains an exception to the Excess Business Holdings Excise Tax for wholly owed, independently operated, philanthropic business holdings. There are three requirements: 100% ownership of the voting stock is held by the foundation at all times during the year and all of the ownership interests were acquired by gift or bequest All business profits must be distributed no later than 120 days after the close of the taxable year Independent operation (i) no substantial contributor or member of his family is a director, trustee, manager, employee or contractor of the business and (ii) a majority of the board of the foundation are not directors or officers or family members of a substantial contributor; and (iii) there are no loans outstanding from the business to a substantial contributor or any family member. A 501(c)(3) Private Foundation is a permitted shareholder of an S Corporation, but it is subject to tax on its Unrelated Business Income. Royalties are excluded from UBI.
501(c)(4) Organizations IRC 501(c)(4) organization include social welfare organizations which are nonprofit and organized for the promotion of the common good and general welfare of the community as a whole, and local associations of employees, in which membership is limited to employees of a designated person or persons in a particular municipality and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes. Provided there is no private inurement. Under the Protecting Americans from Tax Hikes Act of 2015 IRC 2501(a) was amended to specifically exclude from federal gift tax transfers of money or other property to an organization described in Paragraph (4), (5), or (6) of 501(c) and exempt from tax under 501(a). NOTE: The exemption does not apply to transfers at death (i.e., subject to estate tax).
Excise Tax Workaround Recapitalize Corporation Stock. Create 5,000 shares of voting Common and 95,000 shares of Non-Voting Common. Create a IRC 501(c)(4) Social Welfare Organization for the employees of Ernie s Company. If Ernie transfers any of the corporate stock to the social welfare organization, the transfer will terminate the S Corporation status, because it is not a permitted shareholder. The C Corporation Tax Rate (21%) is the same as the UBIT Rate, if organized as a corporation. The C Corporation dividends will not be subject to UBIT. Create a Private Foundation either during Ernie s lifetime or in his estate planning documents. At death, transfer 80% or more of the voting common stock to 501(c)(4) Social Welfare Organization and 20% or less of the voting and all nonvoting stock to 501(c)(3) Private Foundation. The transfer at death of the shares to the Social Welfare Organization would be subject to Federal and Illinois Estate Tax. If the value of the voting was less than $4 million there would be no Illinois Estate Tax. The Federal Estate Tax is not assessed below $11,180,000.
Excess Business Holdings Workaround If the IRC 501(c)(4) organization is not a disqualified person it could hold more than 20% of the voting stock of the same corporation that held inside of the foundation. The IRC 501(c)(4) organization would not appear to be a disqualified person as regards the foundation. IRC 4943(f)(4) defines a disqualified person as It is not an individual It is not a 35% controlled entity It is not a substantial contributor or foundation manager; and It is not a private foundation. The IRC 501(c)(4) would still be potentially subject to: IRC 511 Unrelated Business Income Tax IRC 4958 Excess Benefit Transactions and Excess Compensation concerns
Strategic Giving The 2016 U.S. Trust Study of High Net Worth Philanthropy found that approximately one in four wealthy donors have, or plan to have in the next three years, at least one giving vehicle. In addition, a significant percentage of wealthy donors have a specific strategy and annual budget in place to guide their charitable giving. Only 48.2% had a strategy for their giving. The use of charitable giving vehicles may also allow donors to better monitor the impact of their giving over time while seeking to maximize tax and financial benefits. Moreover, charitable giving vehicles offer the opportunity to involve children and grandchildren in the charitable gifting or granting process. By structuring giving, families can help build and enhance a family legacy of philanthropy, allowing donors to pass along values along with their assets to younger generations.
Questions? Brian T. Whitlock, CPA, JD, LLM 310 S Michigan Avenue #2000 Chicago, IL 60604 Phone (312) 925-9409 E-mail: taxgenie@yahoo.com