Gifting Whitepaper
GIFTING WHITE PAPER
William J Fahey
October 2021
This White Paper is not meant to provide tax or legal advice. Every individual has different facts and circumstances that create different abilities to enjoy tax and investment benefits. People have different goals. For example, is your goal to leave an estate to your children or are current tax benefits more important? There are avenues to meet both goals through charitable gifting. Proper gifting may provide benefits to the Donor substantial enough to offset the value of the donation. Examples included in this paper will illustrate options for the reader to consider.
Before venturing down any path that this White Paper introduces, you must sit down with your accountant (who is familiar with your situation) and an attorney who specializes in tax matters.
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The First Story
A Donor can gift in several ways. A Donor should be aware that the ability to enjoy deductions from cash and non-cash gifts is different. Some of these will be discussed here.
A Way to Gift
One way to gift is to donate to charity a future or residual interest in property. The Donor will still have use of the property for their lifetime, referred to as a life interest.
The example used here describes a donation of a 50% residual interest in a $1,600,000 home to charity while retaining a life interest. A life interest allows the Donor (such as an individual or married couple) to live in the house for life. At the death of the second Donor (husband or wife) 100% of the gift, which in this event is a 50% interest in the home, becomes the property of the charity or charities. The other 50% remains in the Donor’s estate and may go through Probate or as the asset’s title (deed) dictates. Is the Donor deducting 50% of $1,600,000? No. The Donor is retaining some of the benefits of the home, specifically the ability to live there for life. The charity does not receive $800,000 today but at some time in the future, specifically at the second death of the two Donors. The deduction the Donor receives depends on the age of the Donor or the Donors. The younger the Donor, the smaller the deduction because the IRS recognizes that the charity may have to wait longer to receive the gift. A 72-year-old male and a 68-year-old female will be able to deduct approximately 92% of $800,000 or $736,000.
How does the taxpayer enjoy the $736,000 deduction and what are the limits? All $736,000 is deductible with two limitations.
The first limitation is recognition that this is a non-cash donation. Non-cash donations may only be deducted up to 30% of the Donor’s Adjusted Gross Income (AGI) as shown on the Donor’s Federal 1040. If the Donor has a $300,000 AGI, the deduction limit for that year is $90,000.
The second limitation is the speed with which the total deduction may be enjoyed. The $736,000 must be deducted over five years plus the current year; in other words, over six years or six tax returns.
Below is an example of how any gap created by this tax method may be closed.
How to Enhance the Deduction and the Gifting Benefits
For the Donor to increase the AGI to allow a higher deduction, use of money in a retirement account may be considered. For example:
Rollover $1.2M from retirement accounts/401K to a Roth IRA. This increases the AGI by a like amount, incurring a taxable event.
Deduct 30% of the increased AGI or $360,000. While the AGI increases by $1,200,000, the taxable income only increases $840,000.
Pay the income tax on $840,000, approximately $300,000, from funds in the Roth IRA, leaving a balance of $900,000.
Thereafter, all distributions from the Roth IRA are tax free for life, including growth in the account.
In addition, Roth IRAs are not subject to the rules that require some minimum withdraws (distributions) that are required of Regular IRAs or 401K type plans (often called RMDs or Required Minimum Distributions).
There is also no Income in Respect to Decedent (IRD), the income tax from retirement plans owned by a decedent at the time of death.
The Donor has a total of $736,000 in deductions to use.
Use $360,000 of the deductions in the year of the gift to lower the Donor’s taxable income increase.
There are still $376,000 of deductions left over ($736,000 - $360,000) to be used to offset other income received in the gifting year and in future years.
The remaining deductions from the gifting may be used over the next five years plus the gifting year or a total of six tax returns.
To use all the remaining deductions ($376,000) the Donors AGI should be approximately $200,000 per year (not counting the rollover to the Roth IRA) for the six years mentioned in #7 above. The taxpayer’s accountant MUST be involved to determine the best gifting amount.
The Donor’s taxable income will be reduced over the six years defined above placing other earned, unearned and portfolio income in a lower tax bracket.
An Anticipated Question
In the above example it appears the Donor is gifting half of their home in exchange for tax free income from a Roth IRA. Are children being left out? Your children (your estate) can inherit the Roth IRA proceeds in full, and the estate will not have to pay income tax. However, Estate Tax may be incurred. Your estate will be smaller using the above example. That said, please read further discussion on the Estate Taxes below.
Estate Tax Discussion
Estate Tax Exemption or Exemption is the amount of your estate not subject to Estate Tax or the amount of your estate that is exempt from Estate Tax. The Exemption is a dollar figure determined by Congress to create a floor below which estates are not taxed. If the Exemption is $10 million and you have an Estate of $15 million, you can expect to pay Estate Tax on a number close to $5 million. This White Paper will not address the various adjustments to the estate tax.
Today (2021) the Exemption is the highest in tax history at $11.7 million or $23.4 for a married couple. During this author’s career the Exemption has been as low as $600,000 or approximately 5% of what it is today. The current tax law expires in 2025, and the Estate Tax Exemption reverts to $5 million, after which the Exemption will be adjusted for inflation. This author believes that Congress may change the exemption sooner.
Four potential taxes are triggered at death. Once again, you must consult your accountant to determine if any of these apply to you.
Income in Respect to Decedent (IRD): Funds a taxpayer has in retirement plans that have not previously been taxed. IRD is taxed as income and computed on your 1040. Roth IRA plans have been taxed and are not subject to IRD.
Federal Estate Tax: As an oversimplification, your estate is what you own less what you owe. For ease of conversation, your Federal Estate Tax is your estate, less the Exemption times approximately 50%.
State Estate Taxes: Every state is different. Maryland, for example, taxes estates over $5 million up to 16%. Twelve states and the District of Columbia have an Estate Tax. Exemptions range from $1 million to $7.1 million.
State Inheritance Taxes: The Inheritance Tax is assessed for the privilege of inheriting property. This tax is 10% in Maryland. Six states have an Inheritance Tax.
The Second Story
What options are available if the taxpayer does not have wealth in retirement plans but may have real estate or company stock?
As a preamble, let us suppose a seventy-year-old has an estate that will trigger an estate tax. One asset he owns is a shopping center with a fair market value (FMV) of $10 million that he built thirty years ago with no mortgage and little basis. The children have no interest in the parent’s business and even less business acumen. The owner might worry about their ability to make clear decisions in the future or when the decisions fall to children who are not in business with the parent. At some point the owner/donor may want to sell. If the owner sells the shopping center for $10 million, the seller could expect to pay tax on the gain, leaving approximately $8 million. The owner will receive income from the principle of $8 million. When the owner dies the 50% estate tax will leave $4 million to be shared by the children. That does not sound like much from a $10 million starting point. There is a more strategic way to sell the property and provide for the owner now and the children/estate after the owner dies. (Note: This model applies to an executive who wishes to sell their high-tech company or a career executive who wishes to retire and has substantial assets in his/her employer’s stock.)
One solution is to contribute the shopping center to a Charitable Remainder Trust (CRT) that the owner/donor creates. The shopping center and its revenue remain in the Donor’s control for life but must irrevocably go to one or more charities at the owner’s/donor’s death. The children receive nothing at this point in the transaction. The Donor receives a deduction based on age. From published IRS tables we determine a factor that is multiplied by the shopping center’s value to determine the charitable deduction.
Let us make a realistic example of the Donor receiving a $7 million deduction. The ability of the taxpayer to enjoy this deduction is the same as noted in the first story. In the Donor’s tax bracket this deduction is worth approximately $2.3 million. The Donor uses the $2.3 million to purchase a $10 million life insurance policy, or value that $2.3 million buys. The policy is owned by someone other than the Donor, perhaps the spouse. If the Donor is uninsurable or poorly insurable, then we underwrite the spouse. If neither is insurable or are poorly insurable, we could insure one or more of the children, and the plan still works beautifully. The children receive the $10 million insurance proceeds net of tax, plus or minus. Let us review the transaction:
The children receive $10 million +/- vs. $4 million.
Donor receives income for life from a principal of $10 million vs. $8 million, a 25% increase.
The Donor receives recognition from the charity/charities, perhaps even naming rights for a building or program.
Other Thoughts, Questions and Considerations
What happens if the Donors have contributed 50% of a home as in the first example and later in retirement wish to downsize or move to a retirement community or apartment? As noted, the charity(ies) own half of the future interest in the house. If you have a $1,600,000 house and the charities own half and you wish to downsize, the sale proceeds of the first (larger)house must be recognized according to the percentage of ownership. Let’s suppose you wish to downsize to a $1,000,000 house. The charity(ies) will own half of the replacement home or a value of $500,000. The taxpayer/donor will also own a like amount. What happens to the $600,000 netted at closing? Half of those funds go to the charity(ies) at closing as they own half of the first house. The taxpayer may not keep more funds from closing in exchange for the charities owning a larger percentage of the house. Let’s suppose the taxpayer wished to give the charities their $800,000 in the form of an 80% interest in the replacement house and would keep for himself a 20% interest in the replacement house plus $600,000 in cash. If the replacement house decreased in value, the charities would suffer disproportionately. The taxpayer would have $600,000 to invest as he/she wished while the charities would receive nothing. I would expect the IRS to contest anything that does not preserve a 50/50 deal.
Should the couple in the original transaction divorce, or should a spouse remarry after the death of the first spouse, the transaction is still in effect. The charity retains 50% interest in the house. When the second Donor dies, the life interest expiries, the house sells, and the charity receives their portion of the proceeds.
Conclusion
This paper attempts to outline ways that individuals and couples may pursue methods to minimize death and/or income taxes and be donative while preserving some, if not all, of their estate for heirs.
The figures in this paper are large for many middle-income taxpayers. These taxpayers may enjoy the benefits of the first story at some level. Middle income taxpayers are not subject to federal estate taxes since there is a $23 million exemption, so the second example would have little application. The real winners are the charities who without donative planning would not be receiving these types of funds.
This paper uses a 50%/50% example throughout. There is nothing magical about these percentages. A 60/40, 70/30, 100/0 or another ratio will work. The taxpayer should seek professional assistance to learn how gifting may create a win-win situation for you, your spouse, and your descendants.
For More Information
William Fahey, the author of this White Paper, can be reached at (703) 989-6438. The author has participated in similar transactions to those reported here. There are numerous other transactions that can be designed for those with donative intent, including Charitable Lead Trusts. Please feel free to start a dialogue. Expect your accountant and attorney to be required attendees early in the process.
Definitions
The author provides the following definitions in lay language, not to be construed as legal definitions.
Donor: The person(s) making the gift.
Charities /Not for Profits: There are approximately 29 501(c) categories of nonprofits ranging from 501(c)1 to 501(c)29. While each of the 501(c) entities themselves are tax exempt not all may receive donations that are deductible to the Donor. For example: 501(c)3 (Charitable, Religious, Educational and many others) and 501(c)23 (Veterans Organizations) may receive donations that are deductible to the Donor. 501(c)6 a trade association, may receive a donation that is not deductible to the Donor. Check with your accountant to confirm that your donation is going to the proper organization that meets your goals.
Probate: The legal (judicial) process wherein the deceased’s will is validated or “proved.” The Probate Court manages the process and appoints the Executor (or Personal Representative). What transpires in the probate court is usually public information.
Adjusted Gross Income (AGI): This figure can be found near the bottom of the taxpayer’s Federal 1040. It includes all the taxpayer’s income but not the taxpayer’s deductions or credits. See your accountant.
Roth IRA: A type of Individual Retirement Accountant (IRA) where contributions are not deductible, but the growth is tax free (not simply deferred), and all distributions are tax free (not simply deferred). In addition, Roth IRAs are not subject to any of the rules that require some minimum withdraws (distributions) that are required of Regular IRAs (often called RMDs or Required Minimum Distributions). An individual taxpayer may roll all or part of their Regular IRA or their 401(k) (and other retirements) into a Roth IRA. Please note 100% of every dollar rolled over to a Roth IRA will be taxable in the year of the rollover. For some taxpayers that could trigger hundreds of thousands of dollars of immediate federal tax. At the taxpayer’s death the Roth IRA funds are not subject to income tax. The Regular IRA and 401(k) funds are subject to income tax (sooner or later). This is called Income in Respect to Decedent (IRD).
RMDs: See Roth IRA
IRD: See Roth IRA
Life Interest: Typically, an owner of a Life Interest has the right to use an asset for the Life Interest’s owner’s life. The owner may be a married couple upon which the Life Interest is for the longer to live of the husband and wife.