For charitably inclined individuals, there is a significant amount of uncertainty brought on by possible policy shifts that may occur if former Vice President Joe Biden is elected and Democrats take a majority in the Senate. We have listed the general proposals here. It is worth restating the caveat that this is all speculation. Foley is hosting a webinar on November 10th about the likelihood of tax changes (and whether the changes will likely be effective January 2021 or later).
Increased Income Tax Rates; But Limitations on the Charitable Income Tax Deduction
Under the Biden plan, income tax rates on individuals with high incomes will increase, and in some cases, significantly. This usually means the charitable income tax deduction generated by charitable gifts becomes more valuable (providing an incentive to make charitable contributions), but that may not be the case under Biden’s proposals. In general, his proposals seek to increase the progressivity of the income tax by limiting deductions for high-income taxpayers. Biden’s proposals contain a provision that would limit the value of all deductions to 28%.
Under current policy the charitable income tax deduction generally decreases the taxable income at the highest rate income the taxpayer pays. Because of this, the implied value of a charitable income tax deduction is the taxpayer’s marginal tax rate (for high-net-worth individuals under Biden’s plan, this rate increases from 35% and 37% to 39.6%). In contrast, under Biden’s proposal, the deductions would not be deducted from the taxable income. Instead, deductions would generate a credit against tax equal to the value of the deductions multiplied by 28%. A charitable income tax deduction for all itemizing taxpayers may be limited to this 28%.
Charities will try to make the case that the charitable income tax deduction should not be included under this treatment. Further, in any type of tax reform package, charities will look to expand the availability of the income tax deduction for those taxpayers who do not itemize. For individuals who no longer itemize, the CARES Act contained a permanent provision that allowed individuals taking the standardized deduction to claim a $300 charitable income tax deduction. Notably, this provision only applied to contributions made to public charities and operating foundations (but not to supporting organizations, non-operating private foundations, and donor advised funds).
The Biden proposals also include reinstated the Pease Limitations. The Pease Limitation disallows income tax deductions for high-income taxpayers. This may also decrease the value of a charitable income tax deduction in certain cases.
Deferring or Avoiding a Recognition Event
If the tax rate increases, charitable income tax planning that defers or avoids a taxable event will be very important. If the capital gains tax is increased to 39.6% for individuals with $1,000,000 in income, there will be a larger incentive to make a gift of appreciated property (thereby avoiding the tax on appreciation), or to fund a charitable remainder trust and to defer the gain on appreciated property (for property contributed to a charitable remainder trust, the gain from the sale can be deferred until the beneficiary receives funds from the unitrust). Depending on exactly how the limitations apply, an individual in a state with a high-income tax rate who has a large recognition event (such as the sale of a company) may find that the after-tax out of pocket “cost” to make a gift is a fraction of the value of the gift.
Once the estate tax exemption reverts back to $5.8 million (either in 2026, or sooner, if the expansion to $11.6 million in the 2017 Tax Cuts and Job Act is repealed), charitable lead trusts will be more popular as a way to leverage the estate tax exemption to pass more assets to later generations. Charitable lead trusts work well with low interest rates (because a low interest allows the taxpayer to set a low annuity rate; any growth of assets in excess of the low annuity rate accrues to the individual remainder beneficiaries of the trust). If the Biden proposal to take away the basis step-up is adopted, estate planning strategies like charitable lead trusts look comparatively better than the alternative (currently, if the assets are subject to the estate tax, the assets will receive a step-up in income tax basis, which generally lowers the overall out-of-pocket cost of the estate tax).
At this time, any thinking on future tax changes is largely speculation; there are many variables to consider (it is possible, but unlikely that changes would occur in 2021; it is more likely that these changes will occur effective in 2022—see our insight here).
In any case, it seems to be a good bet that philanthropic individuals should be considering making large contributions before the end of 2020—which, because of temporary provisions in the CARES Act, provides a unique situation for charitable gifts. Cash gifts can be deducted up to 100% of the taxpayer’s adjusted gross income if the gift is made to a public charity or a private operating foundation, and up to 60% if made to a supporting organization or donor advised fund. See our on the CARES Act provisions.
One warning—using a mechanism that defers income into a future year (such as a charitable remainder trust) may not make sense, given that income taxed in 2020 is subject to a 20% capital gain rate, but in 2021 (assuming all Biden proposals pass) individuals with income in excess of $1,000,000 may be subject to 39.6% rate. For high-net-worth individuals considering a charitable remainder trust, it may make sense to consider triggering tax before funding.