In the spirit of the holiday season, here’s a run-down of the 12 days of Christmas.
Oops, I mean the 12 ways of gifting…
1. Annual cash gift(s) to charity.
Making cash gifts to charity offers taxpayers a federal income tax deduction, subject to limits based on adjusted gross income and the type of qualifying charity.
Planning Tip: The cash gifts made to the charity can be leveraged with life insurance. That is, the cash gift may be used by the charity to purchase life insurance on the “key” donor, subject to charitable underwriting requirements by the insurance carrier.
2. Name charitable beneficiary of a life insurance policy.
A donor can purchase a life insurance policy on his/her life and name a charity as beneficiary. Alternatively, a donor can change the beneficiary of an existing policy to be a designated charity. Note that a federal charitable income tax deduction is not available on the premiums paid. Instead, the donor’s estate will receive a testamentary charitable deduction at death on the final federal tax return.
3. Bunching-up gifts.
Under the 2017 Tax Reform Act, tax filers are no longer allowed to deduct the state and local taxes (SALT) they pay in excess of $10,000, in total, on their federal tax returns. With the standard deduction for married couples at $24,000, it won’t make sense for most taxpayers to itemize. This means that if deductible items, like charitable contributions, are not in an amount above $24,000, their below-the-line deductible expenses are capped at the standard deduction. The standard deduction for individuals is $12,000 and for Head of Household is $18,000.
Planning Tip: Charitable gifts of cash or securities can be deducted provided the taxpayer itemizes deductions. If clients have been long time donors to a charity and the standard deduction amount limits the benefit from making the annual gift, it may make sense to “bunch-up” charitable contributions in a given year in order to itemize. The “bunched up” contributions can also then be placed in a Donor Advised Fund (DAF) which will distribute the funds to charity over a period of time.
4. Charitable gift of $100,000 IRA distribution.
Owners of a traditional or ROTH IRA can make a gift of up to $100,000 from the IRA direct to charity from the retirement account, provided that the owner has reached age 70 ½. The gift must be made to a qualified charitable organization other than a private foundation or a Donor Advised Fund.
Although it is possible for a donor to take custody of a distribution directly from the IRA and then turn around and make a gift of it to a qualifying charity, the distribution would then be included in income on the tax return for the year the gift is made. The donor would subsequently receive a charitable income tax deduction when making the gift to charity. However, it is important to note that the donor would then be subject to:
- adjusted gross income limitations on the amount of the federal tax deduction allowable,
- the deduction phase-out rules,
- potential state income tax limits on the deduction, and
- a possible increase in taxes on social security income as a result of an increase in base income caused by direct receipt of the IRA funds.
Moreover, the charitable rollover is included in determining the amount of RMD (Required Minimum Distribution) and as long as the RMD is equal to or less than the IRA contribution, the RMD would bypass the tax return and would not be included in taxable income for that year.
Planning Tip: The charitable IRA contribution can be increased with life insurance by having the charity use the distribution to purchase a single premium life insurance policy on the donor’s life. For example, a 71-year old female, non-smoker, preferred underwriting class may purchase approximately $180,000 of life insurance, leveraging the $100,000 single gift by $80,000. Again, the purchase of insurance would be subject to underwriting guidelines.
5. Use-it-or-Lose-it of gifts.
Individuals can make annual gifts of $15,000 to anyone each year without paying gift tax, and without having to report the gift or use part of their lifetime gift tax exemption amount each year. This offers parents and grandparents an opportunity to make tax free gifts. Therefore, two grandparents together can give up to $30,000 per recipient per year with no reporting requirement.
Taxpayers can also shelter a certain amount of gifts, during lifetime or at death, from estate, gift and Generation-skipping (GST) taxes. We refer to these amounts as the lifetime exemption amount or the applicable exclusion amount. Prior to the 2017 Tax Act, the exemption amount was $5.5 million per individual ($11.2 million per married couple). The exemption has now doubled under the new law, pegged at approximately $11.18 million per person (or $22.36 million per married couple). This higher amount leaves very few estates subject to the estate tax.
Planning Tip: The higher exemption expires in 2026, at which point this exemption will revert back to the pre-2017 Tax Act exemption amount, indexed for chained CPI, and estimated to be approximately between $6.3 – $6.5 million in 2026. This means wealthy families will lose the opportunity to plan with the additional exemption amount after 2025 if not used before. Gift planning should take into account this ‘sunset’ exemption, in addition to the size of a client’s current estate, its expected growth, and the age and health of the client. Moreover, liquidity needed to equalize gifts among heirs, as well as to create opportunity for heirs to buy each other out of unwanted assets, must be considered carefully.
6. Direct gifts of tuition by grandparents.
Grandparents can make direct tax-free gifts of any amount to medical and educational institutions to benefit their grandchild. There are also no reporting requirements for payments made by grandparents directly to medical or educational institutions.
7. Gifts to 529 Savings Plans.
With the new tax bill, parents and grandparents who send their children to private elementary and high schools will have more options when it comes to saving for tuition. Up until now, the only vehicles that offered tax-free savings for K-12 were Coverdell Education Savings Accounts (ESAs). With tax-free earnings growth and tax-free withdrawals for qualified purchases, Coverdell ESAs operate very similar to a 529 savings plan. However, with ESAs there are earnings eligibility limits, annual contribution limits of $2,000 and a contribution deadline of age 18. Compare the Coverdell’s maximum annual contribution to that of a 529 plan in which there is no maximum. However, care should be taken to not run afoul of the gift tax rules when making deposits to a 529 plan.
In 2018, gifts totaling up to $15,000 per individual will qualify for the annual gift tax exclusion. This means a set of grandparents who have three grandchildren can gift $90,000 without gift-tax consequences, since each child can receive $15,000 in gifts from each grandparent. This total amount reflects total annual tax-free gifts including non-529 gifts. Gifts above these amounts would need to be reported on gift tax form 709, even if no gift taxes apply.
There is also a 5-year contribution rule for 529 plans that allows parents and grandparents to make 5-years’ worth of annual exclusion gifts, or $75,000 ($15,000 x 5) to a 529 plan for each beneficiary. The amount is pro-rated over the five years, so that a $50,000 contribution would be applied as $10,000 each year, leaving you with $5,000 in unused annual exclusion.
Planning Tip: The 2017 Tax Reform Act allows distributions from 529 plans of up to $10,000 and may now be used for “qualified expenses” for elementary school and high school. Prior, 529 funds could only be used for post-secondary “qualified educational expenses”, such as tuition, room & board, and books.
8. Gifts to a Charitable Lead Trust.
Charitable trusts are often used by wealthier and higher-income clients to make charitable gifts while also providing an inheritance for the family. This is referred to as a split-interest trust. In the current low interest rate environment, a Charitable Lead Trust (CLT), structured as a grantor trust, can be effective in transferring an income stream to charity for a term of years, for which the donor receives a charitable income tax deduction (based on the present value of the income stream going to charity) in the year the gift is made. Although the taxes on the income generated by the trust must be paid by the client, it may be possible in some circumstances to minimize or eliminate taxation to the grantor by managing the types of assets in which the CLT invests. The CLT remainder typically transfers directly to children, or to a trust on their behalf, at the end of the trust term.
Planning Tip:It may be possible to leverage the remainder balance for the non-charitable beneficiaries of a CLT with a life insurance policy. Sometimes, a CLT can pour into an insurance trust to repay loan principal on an intra-family or third-party premium financing arrangement used to fund a life insurance policy.
9. Gifts of partnership interests.
Wealthy clients can make charitable gifts of Family Limited Partnership (FLP) or LLC interests to a Charitable Lead Trust (CLT). In so doing, the client continues to control the assets of the FLP/LLC while getting a charitable income tax deduction. At the same time, the client is pooling and thus diversifying the assets in the CLT to make it more tax efficient when making the income payments to charity. By diversifying the CLT assets in this way, the trustee of the CLT can minimize liquidating assets and incurring income taxes in the process of creating income for the charity. Since the CLT remainder benefits non-charitable beneficiaries, typically the children of the donor, it benefits the donor to pool assets and preserve the principal value of the FLP and CLT assets.
10. Gifts through an LLC.
A client can make contributions to a Limited Liability Company (LLC) that houses a business or is being used to manage a portfolio of assets or property. At some point later, the LLC can make a donation to a charity the client supports. In this way, the LLC serves as a conduit for making the charitable gifts. When the client is ready to make the gift and can use the income tax deduction, the LLC makes the donation and passes through the deduction. The client retains control over the LLC assets and avoids the investment restrictions associated with charitable trusts. Note that the charitable income tax deduction can only be taken when the LLC actually makes the gift to charity, not when the contributions to the LLC are made by the client.
11. Charitable gift of the earth.
Landowners who place a qualifying conservation easement under IRC 170(h) on their property can benefit from a federal income tax deduction against adjusted gross income (AGI). The deduction is limited to 100% of AGI for farmers and ranchers, and to 50% of AGI for everyone else. A 15-year carryforward for any unusable deduction is available, subject to the same AGI limits annually. There are also potential state tax credits available, local property tax and estate tax benefits. The easement is a restriction on the development and use of the property. It is based on protecting the land’s conservation attributes and therefore lowers the fair market value of the land relative to its development value. The federal income tax deduction available is based on the value of the property before and after placement of the easement. In some cases, the deduction can be significant enough to help conservation-minded property owners manage large income tax years.
A conservation easement is a voluntary “use restriction” added to the property deed. This restriction is legally binding and must remain with the land forever. Essentially, the restriction is an agreement to permanently limit the extent to which the land can be developed in the future. The landowner continues to own, use and enjoy the land and can continue to sell, gift or bequest it in the future, as usual. Placing a conservation easement on qualifying land can help a landowner to both protect the land and benefit from significant tax savings.
Planning Tip: Life insurance can be used to restore the economic value lost from the easement. A portion of the tax deduction can be used to fund the premium. In this way, the life insurance makes heirs whole and converts a portion of the property value to a liquid asset.
12. Charitable gifts may reduce taxable income for purposes of the new 199A thresholds.
The 2017 Tax Act provides businesses structured as pass-throughs a special deduction. Small businesses that do not operate as a C-corporation and instead “pass- through” their qualified business income (QBI) to their individual tax return, may now be eligible to deduct 20% of QBI. Businesses structured as Sole proprietorships, and partnerships set up as limited liability companies (LLC) or Family Limited Partnerships (FLP), as well as S-Corporations and trusts may be able to take advantage of the new 199A deduction. However, there are complex rules that govern the extent of the tax benefits and impose deduction limits for ‘service’ businesses defined as STTB, described below.
Effectively, those pass-throughs that can benefit from the 20% deduction will effectively pull their new individual top tax rate of 37% down to 29.6% when using the 20% deductibility in full.
However, certain service businesses structured as pass throughs– such as law firms, accounting firms, investment firms and physician practices– can take advantage of the 20% write-off only if taxable income is less than a threshold amount: $315,000(MFJ), or $157,500(S). That is, the 20% deduction is phased out over the next $100,000(MFJ) and $50,000(S) of taxable income, respectively—after which no deduction is allowed for these “service” firms–referred to in the code as Specified Service Trade or Business (STTB). The deduction for taxable income above $415,000 (MFJ) and $207,500 (S) is not allowed. Interestingly, a special exception was made for architect and engineering firms (which are “service” firms) so that they do not fall under the STTB rules that limit the deduction.
Planning Tip: It may be possible for taxpayers, especially those with pass-through businesses that are a STTB, to make charitable contributions that have the effect of lowering their QBI. By lowering QBI, the STTB taxpayer may benefit from the 199A deduction that would otherwise not be available due to the income threshold limits.