On Giving Gifts

“Think of giving not as a duty but as a privilege.” – John D. Rockefeller, Jr.

Giving significant gifts is a way to reduce “income inequality.” We can think of this as “direct action.” While this post is intended to clear up some questions about the tax implications of giving, we will leave promotion of charitable giving, with all its societal benefits, for another day.  This short overview will only scratch the surface of the many giving strategies available.

People are asking me more these days about giving gifts. This is probably because of growth in the stock market which is making them feel wealthier. It is also because of the reality of impending tax increases and taxes due today on unrealized gains.

The most common misconceptions are:

• I’m worried that if I give a gift, I will have to pay gift tax. (No, unless you are very generous indeed.)
• If I give a significant gift to someone in my family, is it tax-deductible? (No.)

When giving to churches or other charities, most people think of writing a check, or giving cash. A gift of cash to any public charity, basically a 501(c)(3) organization. These non-profits exist to promote religious, educational, scientific, or artistic endeavors, amateur sports, and prevention of cruelty to animals and children. Amounts donated are deductible on Schedule A, for those who itemize deductions. In 2021, those who do not itemize may deduct up to $300 ($600 for Married Filing Jointly) of cash contributions. Under the Tax Cuts and Jobs Act (TCJA), the standard deduction has been raised; in 2021 it is $12,550 per person (with variations for filing status). This change in the tax code made it harder to get a tax benefit from the deduction, leading to the introduction of the “above the line” limited charitable contribution deduction.

Gifts of cash are probably the least tax-efficient way to give. Cash donations are generally made with money that has already been taxed and are subject to the “Schedule A floor” or standard deduction limit as described above. There are other ways to give, and these also reduce taxes that would apply in the future. The most common alternatives are gifts of appreciated securities and Qualified Charitable Distributions from an IRA.  We’ll return to this shortly.

Gifts to individuals are not tax-deductible, but they are also not income to the recipient. Thus, if grandma wants to write a check to her grandson, there is no tax reporting for either of them, until the Annual Exclusion amount for the gift tax is reached, currently $15,000. Gifts above this amount must be reported by filing a Gift Tax Return (Form 709) but no Gift Tax is due unless the value of all lifetime gifts exceeds $11,700,000. These amounts effectively double for a married couple. Often, people will avoid giving large gifts, because they fear they will incur gift tax, or that a recipient will have to pay income tax. But the situation is more nuanced. A good financial advisor can help you determine the best strategies to use in your unique situation.

Gifts of appreciated securities can reap tax benefits for donor and recipient. Suppose you have shares of stock or a mutual fund that you purchased 20 years ago for $10,000, and which is now worth $100,000.

Now, let’s compare the tax impact of giving cash vs. appreciated securities.

If someone makes a gift of $100,000 in cash to a charity, they can deduct it on Schedule A, subject to the limitations described earlier. However, if that same person has appreciated stock worth $100,000 with unrealized gains of $90,000, not only is it fully deductible (if donated to charity) but also $90,000 of future capital gains income is eliminated.  Such a gift may also help rebalance a portfolio, reducing investment risk.

Although the same gift to an individual would not be tax-deductible, and would require filing a gift tax return, the $90,000 in capital gains is still eliminated for the donor. Also, the recipient now has unrealized gains of $90,000, because the basis of a gift such as this is transferred to the recipient. Still, if the recipient is a young person with low income, it may be possible to sell the stock and realize the gains, while remaining in the 0% capital gains tax bracket, something grandma may not be able to do, if she has other investment, pension, or Social Security income. A single person can realize capital gains at 0% tax rate if their taxable income remains below $40,400 ($80,800 Married Filing Jointly). Although California will tax these gains at the same rate as ordinary income, by spreading out the stock sales over time, the recipient may be able to avoid paying any federal tax on the gain income.

We can see that gifts of appreciated securities are more “tax efficient” than gifts of cash and are almost always a preferred way to give money when the option exists.

Another tax-advantaged way to give is Qualified Charitable Distributions from a pre-tax IRA account. If the taxpayer has a pre-tax IRA, and is age 70.5 or older, he or she can direct the plan trustee to distribute up to $100,000 per year to charity. This is known as a Qualified Charitable Distribution, which is not subject to tax. Although such donations are not deductible on Schedule A, they do allow people to avoid the tax that would otherwise be due on a regular distribution. What’s even better, these QCDs satisfy the Required Minimum Distribution that applies starting the year the taxpayer reaches age 72. Making a QCD reduces the overall size of the IRA and can result in lower Required Minimum Distributions (RMDs) in future years.

Now this is something truly remarkable: under the right circumstances, you can give money away, that you never paid tax on, and with no “floor” as imposed by Schedule A. The use of QCDs is most advantageous for older taxpayers who may have paid off their home mortgage and who have limited or no itemized deductions. It can be used by anyone over age 70.5. Usually, the IRA trustee limits the minimum amount for a QCD to $500 or $1,000, but this is low enough to avoid the Schedule A limitation of giving cash from a taxable account.  QCDs can only be made to charities, not individuals, and not (see below) to Donor Advised Funds.

Donor Advised Funds. Sometimes, a person will have a year with very high taxable income. This can happen when there is a large bonus, stock compensation, sale of a home, or a severance payout. The extra income can push the taxpayer into a higher bracket. Frequently, this will happen shortly before retirement and transition to a lower income and lower tax bracket.  In these cases, a tax deduction in the current year will be worth more than it would be in a future year.

One solution to this is to establish a Donor Advised Fund (DAF). DAF contributions are tax deductible. The DAF invests money received, which can grow. A separate account balance for each donor is tracked. When the donor requests a disbursement, the DAF management issues a donation, generally as advised by the donor. The fund manager does not have to follow the instructions of a donor (hence “advised” instead of “directed), but they generally do.

Say a donor has an extra $1M received from the sale of their home, or from a severance payout. This is clearly going to put them into the 37% tax bracket.  By contributing to a DAF in the year, a one-time tax deduction for the amount contributed, can be claimed, up to the annual limit.  Over succeeding years, the donor can then direct contributions to their favorite charities, while their money is still growing. If planned properly, this can significantly reduce lifetime tax liability, while maintaining continuous support for charities.

Charitable Trusts. We don’t have space in this post to go into all the strategies involving Charitable Trusts.  Typically, the taxpayer will use a charitable trust strategy to avoid paying estate taxes, or to provide for a charity with the remainder of their estate, after other priorities are met. The donor can receive income from distributions of the trust, after receiving a tax deduction when the trust is established. At the end of a fixed term, or upon the death of the donor, the chosen charity receives the remainder of the assets. In this way, donors can ensure their lifetime needs are met, while leaving a significant bequest to charity, and saving tax at the same time. While Charitable Trust strategies have fallen out of use in recent years, with the proposed reduction in the estate tax exemption, they may be making a big comeback in the near future.

Gifts of unused items.  Another common giving strategy is to donate used items to a charity. These non-cash contributions are subject to detailed recordkeeping and a special tax form, Form 8283, if they exceed $500 to any single recipient, in a given year. This includes the donation of an auto, which is subject to its own set of rules.

Paying education or health care expenses. The last strategy we will cover in this post is to pay education or health care expenses directly to a provider. Although cash gifts are subject to a $15,000 annual gift tax exclusion, if a donor pays tuition directly to a school (rather than giving them cash to do so), there is an unlimited exclusion. A parent or grandparent can pay directly to the school and avoid completing form 709.  The same exclusion applies when medical expense payments for another person are made directly to the provider.

There are many ways to give, and it is said that everyone loves a cheerful giver. At some point, those who are fortunate, or who simply worked, saved, and invested, may find themselves with more assets than they need for the rest of their lives.  This is an opportunity to act directly to change the world.

By following some common-sense rules, you can also give without being taken to the cleaners by the tax man.