[Editor's note: The following article was prepared by Wachovia Trust Nonprofit and Philanthropic Services.]
Conventional thought is that when federal income tax and/or capital gains tax rates decline, charitable contributions will also decline, and vice versa. The reasoning: When rates decline, donors lose some of the tax advantage of their charitable donations, making the after-tax cost of their gifts greater. When rates increase, the value of deductions also increases and gift costs decrease, which may be an incentive for people to give more.
Under this reasoning, nonprofit organizations might look to the upcoming expiration of the current reduced federal tax rates on ordinary income and capital gains as an opportunity for increased contributions. Unless Congress takes action, the current rate schedule will revert to the pre-2001 rate schedule in 2011. However, for affluent donors in particular, conventional thought may not hold true. Past experience seems to indicate that these individuals give more when tax rates are lower.
Tax Rate Schedules
Individual Long-term Capital Gain
Current 2011 (pre-2001) Current 2011 (pre-2001)
10% 15%* 20%
* 0% for gain otherwise taxable in a 10% or 15% tax bracket
The Value of Tax Deductions
Basically, donors who itemize their deductions for federal income-tax purposes can claim a charitable deduction for the fair market value of gifts they make to a qualified charitable organization, up to 20%, 30%, or 50% of adjusted gross income. The amount of the deduction allowed will depend on the type of property donated and on the type of recipient. A lower tax rate means that a contribution carries a higher after-tax cost.
Example: Let's say that Bob made a $100,000 cash contribution to his alma mater's endowment fund in 2000 before the income-tax rate cuts introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001 and accelerated by the Jobs and Growth Tax Relief Reconciliation Act of 2003 started taking effect.
Also assume he was in the highest tax bracket in 2000 - 39.6% - and that the entire $100,000 was deductible in 2000. The tax savings from Bob's deduction would have been $39,600 ($100,000 × 39.6%). Thus, his gift would have cost him $60,400 on an after-tax basis.
However, if he had made his gift a year later when the top rate had dropped to 39.1%, his gift would have cost him $60,900, or $500 more. In 2003, when the top individual income-tax rate had decreased to 35%, the same $100,000 gift would have had an after-tax cost of $65,000.
Another tax provision that has an impact on the tax benefit from a charitable contribution is the reduction of itemized deductions for higher income individuals. For these individuals, the amount they can claim for certain itemized deductions, including charitable contributions, is reduced as their adjusted gross income exceeds a certain limit ($159,950 in 2008/$79,975 if married filing separately). Because this provision effectively raises taxes without raising the tax rates directly, it is sometimes referred to as a "stealth tax."
Under the provision, once adjusted gross income exceeds the threshold, certain otherwise allowable deductions are reduced by the lesser of (1) 3% of the amount over the threshold, or (2) 80% of the otherwise allowable itemized deductions for the year.
However, for 2006-2009, taxpayers have been given a break that lessens this reduction, thereby increasing the value of their deductions and, consequently, reducing the after-tax cost of charitable gifts. In 2006 and 2007, higher income individuals lost only two thirds of the deduction amount they would have otherwise lost, and in 2008 and 2009, they lose only one third. In 2010, the itemized deduction reduction is repealed. However, unless Congress changes the law, it will be reinstated in 2011.
Example: In 2008, Dave and Mary have adjusted gross income (AGI) of $350,000. For simplicity, assume that their itemized deductions for the year consist solely of a $50,000 donation to a local charity. Their AGI is $190,050 over the reduction limit. Under the old rules, the deduction for their gift would be reduced by $5,702 (3% of $190,050) to $44,298. But under the 2008 rules, they lose only one third of $5,702 or $1,901. So their deduction is only reduced to $48,099. In 2011 and later, they would lose the full $5,702.
Gifts of Appreciated Property
Making gifts of appreciated property to charitable organizations is a popular planning strategy for affluent individuals. With these gifts, capital gains tax is a consideration. While changes in capital gain tax rates don't actually increase or decrease the cost of a charitable gift, rate changes can make these gifts more or less attractive to some people.
Example: Jill, who is in the highest tax bracket, would like to make a $500,000 gift to her favorite charity. She owns securities worth $500,000 in which she has an unrealized long-term capital gain of $200,000. Jill is deciding between two options for her gift. She can sell the securities, pay capital gains tax, and give the charity the after-tax proceeds. Or she can give the securities directly to the charity and avoid having to pay capital gains tax. Note, too, that a charity receiving such a gift will generally not have to pay capital gains tax on a later sale of the gifted property.
Here's a look at the gift strategies showing cash gifts made when the top capital gains tax rate was 20% and today when the top rate is 15%:
Capital Gains Capital Gains Direct Gift
Tax Rate Tax Rate of Securities
Value of Securities $500,000 $500,000 $500,000
Capital Gains Tax - 40,000 - 30,000 0
Net Gift to Charity $460,000 $470,000 $500,000
Deduction Tax Savings* 161,000 164,500 175,000
Cost of Gift $339,000 $335,500 $325,000
(Net gift + capital gains tax
- deduction tax savings)
* Assumes an income-tax rate of 35%
You can see why the direct gift is more attractive. Many affluent donors prefer to support specific causes, rather than fund assistance through federal programs.
After-tax Income versus Tax "Cost" of Gifts
Changes in tax rates also affect after-tax spendable income. When rates are cut, spendable income generally rises, and, when rates are increased, spendable income generally decreases. Historically, these spendable income fluctuations seem to have a greater impact on charitable giving than reductions or increases in the value of charitable deductions. For instance:1
- Following the 1981 income-tax rate cut that went into effect in 1982, rather than declining because charitable deductions were less valuable on an after-tax basis, charitable contributions actually increased 24.3% (in inflation-adjusted 2007 dollars) over the next four years before dropping about 5% with the stock market crash in 1987 (see accompanying graph).
- A similar pattern was seen following the 1987 and 1988 tax rate cuts with another stock market decline in 1990 putting the brakes on the increase in giving.
- Even though deductions were more valuable after the 1993 tax rate increase, giving dipped 0.42% in 1994 and inched up only 1.51% in 1995.
- Giving spiked 10.2% following the capital gains rate cut in 1997.
- In the two years after the rate cuts in 2003, average inflation-adjusted salaries for the top 1% of earners rose 18.8% and 22.5%, respectively.2Inflation-adjusted charitable giving during this period, as measured by charitable deductions claimed on high-income tax returns, grew 23.1% and 21.3%.3
Donors Weigh In
Affluent individuals as a group do not see tax benefits as an overriding factor in charitable giving. When asked how their charitable giving would change if the federal income-tax deduction for charitable contributions were eliminated, more than half of the high-net-worth individuals (identified as those households with annual income above $200,000 or a net worth greater than $1 million) participating in a study of high-net-worth philanthropy said their giving would stay the same. Only 7% said it would dramatically decrease.4
Nonprofit organizations may want to avoid putting too much emphasis on tax advantages when working with affluent donors. Tax advantages are just one of the many benefits of a planned giving program. If you would like assistance assessing the tax impact and/or other benefits of a charitable gift - for yourself or for current or potential donors you may be advising for your nonprofit organization - Wachovia Nonprofit and Philanthropic Services can help. Please contact your Wachovia Philanthropic Consultant.
1Giving USA and NPI. Contribution amounts and percentage increases and decreases adjusted for inflation using the CPI-U
2Austan Goolsbee, "Is the New Supply Side Better Than the Old?", The New York Times, January 20, 2008.
3"High-Income Tax Returns for 2003," Statistics of Income Bulletin, Spring 2006; "High-Income Tax Returns 2004," Statistics of Income Bulletin, Spring 2007; "High-Income Tax Returns for 2005," Statistics of Income Bulletin, Spring 2008, Internal Revenue Service
4Study of High Net Worth Philanthropy, The Center on Philanthropy at Indiana University for Bank of America, October 2006
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