Since 1913, when the Sixteenth Amendment introduced the income tax, Americans have found themselves with financial incentives for charity. When the estate tax was introduced three years later, more incentives for charitable donations were created. Although tax rates change, rising and falling with the political tide, the one perfectly legal and actively encouraged way to save on taxes has been to contribute to charity.
Private foundations benefit from four tax incentives designed to encourage charitable giving:
- Current year income tax deductions
- Ability to avoid capital gains tax on appreciated stock
- Income tax-free growth
- Exemption from estate and gift taxes
Example 1 - Single Year Income Tax Benefit
In any given situation, creating a foundation will usually result in both an immediate and a longer-term increase in net assets for the donor and their foundation. That’s because of the tax deductions the donor receives.
For example, suppose a donor, whom we’ll call Bill, plans to eventually leave 25 percent of his estate to charity. He is in the 45 percent income tax bracket (combined federal and state), has $1 million of income, and is considering a $300,000 contribution to his foundation. If he does not make the donation, Bill will be taxed on the full $1 million. He will pay $450,000 in taxes, leaving $550,000 of assets.
If he does make the $300,000 contribution, he pays tax on just $700,000 of income. The foundation gets the full $300,000. Bill keeps $700,000, on which he pays income tax of $315,000—a decrease of $135,000. After he pays income tax, Bill keeps $365,000 in personal assets. The total of Bill’s assets and the foundation’s assets is $685,000, which is $135,000 more than if Bill hadn’t funded the foundation.
The total of Bill’s assets and the foundation’s assets is $685,000, which is $135,000 more than if Bill hadn’t funded the foundation.
Example 2 - Gifts of Appreciated Stock Increase Tax Benefits
In example 1, we assumed that Bill gave cash to his foundation. The income tax benefit will be even greater if he uses appreciated stock. Let’s assume Bill gives $200,000 of stock (appreciated property is limited to 20 percent of adjusted gross income) for which Bill had paid $50,000. He also gives $100,000 of cash. His income tax deduction is still $300,000, saving him $135,000 of income taxes. However, he also avoids a capital gains tax on the $150,000 of unrealized appreciation. At a 20 percent capital gains tax rate, he saves another $30,000 of income taxes.
Example 3 - Income Tax Advantages Over Time
The advantage grows over time because private foundations only pay a minimal excise tax, not income taxes. Suppose Bill is 55 years old and has assets of $12.5 million, which return 8 percent per year, giving him $1 million in income. Also assume that each year he contributes 30 percent of his income to his foundation. His foundation also earns 8 percent, makes the required minimum annual distribution, and pays excise taxes of 2 percent of investment income and foundation management fees of 1 percent of assets.
Using a standard life expectancy, let’s assume that Bill dies at age 82. After those 27 years, his net worth will be $27.7 million, and his foundation will be worth $20.8 million, for a total of $48.5 million.
Now consider the same scenario with Bill’s identical twin Bob, who has no foundation, but each year gives to charity the same amount that Bill’s foundation gives. After that same 27 year period, Bob will have $35.2 million, which is more than Bill, because Bob didn’t fund a foundation. However, Bill, by funding his foundation each year during his life, can increase the total assets under his own control and in his foundation by over $13.3 million.
However, Bill, by funding his foundation each year during his life, can increase the total assets under his own control and in his foundation by over $13.3 million.
Example 4—The Estate Tax Advantage
Again, let’s assume that both Bill and Bob die at age 82. Bill leaves no additional assets to charity because he is already leaving a sizable foundation. Bob decides to leave 25 percent of his estate, or $8.8 million, to a newly created foundation. This leaves his estate with $26.4 million (that is, $35.2 million, less the $8.8 million to his new foundation).
Because the current estate tax rate is temporary, and to make the numbers easier to follow, the following example uses a hypothetical estate tax rate of 50 percent. Estate taxes will take 50 percent of each man’s personal assets. Neither foundation will be affected by estate taxes. Bill’s estate of $27.7 million will go half to estate taxes and half to his son, Joe, who will receive $13.85 million. Bob’s estate, $26.4 million, also goes half to the government and half to his daughter, Carla, who gets $13.2 million.
When Joe and Carla compare notes, they go back over the histories of their father’s financial lives. Both are surprised to discover that the only difference in the twins’ conduct was Bill’s annual funding of his foundation for 27 years. Not only has Bill left Joe half a million dollars more than Bob left Carla, but Joe will now run a foundation with $20.8 million; Carla will run a foundation with less than half that amount.
Not only has Bill left Joe half a million dollars more than Bob left Carla, but Joe will now run a foundation with $20.8 million; Carla will run a foundation with less than half that amount.
