6. Income Limitations on Charitable Deductions, Part 2 of 3

6. Income Limitations on Charitable Deductions, Part 2 of 3

Article posted in General on 11 November 2015| 2 comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 11 November 2015
Print
||
Rate:

Summary

Russell James continues on with his explanation on the income tax deduction limitations of charitable gifts.

VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

6. INCOME LIMITATIONS ON CHARITABLE DEDUCTIONS, Part 2 of 3

Links to previous sections of book are found at the end of each section.

Different income limitations apply to different charitable transfers, depending upon the nature of the gift and the nature of the charity.  The general rule is that deductions from charitable gifts made to a public charity can reduce a taxpayer’s income up to 50%.  This highest 50% level is reserved for public charities and does not apply to gifts to, e.g., private foundations.  The rule is written in such a way that the default income limitation for gifts to public charities is 50%.  However, there is an exception for some types of long-term capital gain, in which case the percentage limitation is 30%.  Although not discussed in this text, there are also special rules for giving qualified conservation easements allowing farmers to have a 100% income limitation for such gifts.
The simplest way to qualify for the 50% income limitation on charitable deductions is to give cash to a public charity.  This is given the highest income limitation because it is a favored asset (not long-term capital gain) being given to a favored charitable entity (a public charity).  There are no special tax benefits from giving cash (e.g., no avoidance of capital gains taxes), so it is a favored asset.  Public charities are generally favored in tax law as compared with private foundations.  That general concept is applied here in that the 50% income limitation is available only for gifts to public charities, not for gifts to private foundations.  As in other areas of charitable planning, the rules for gifts of cash are relatively straightforward, but the rules for gifts of property can become more complex.

To begin with, any ordinary income property gifts to public charities will also receive the 50% income limitation.  As with gifts of cash, there are no special tax benefits from giving ordinary income property, because it is valued at the lower of cost basis or fair market value.  Thus, here is a favored asset (ordinary income property is not long-term capital gain) being given to a favored organization (a public charity), resulting in the highest income limit of 50%.

Several types of property will be treated as ordinary income if sold, and all will receive a 50% income limitation when given to a public charity.  The first example of ordinary income property is creations by the donor.  Thus, if a donor were to build cabinetry for the office of a public charity and donate that cabinetry to the charity, this type of gift would be subject to the 50% income limitation.  (Of course, the deduction for this type of gift is limited to the cost of materials, even if fair market value is much higher.) Other gifts of creations by the donor could include examples such as artwork or a manuscript.

Inventory from a business is also ordinary income property.  In cases where this inventory is given to a public charity, such gifts would be subject to the highest income limitation of 50%.  For example, if the owner of a local hardware store (sole proprietorship) were to donate cans of paint from its shelves to a public charity, the owner’s deduction would be subject to the 50% income limitation.  As before, the amount of the deduction would be the lower of the cost basis in the paint or its fair market value.  This relatively lower valuation is somewhat offset by the ability to use the highest income limitation.
The final major category of property treated as ordinary income is short-term capital gain property.  This is any capital gain property held for one year or less prior to its sale or transfer to the charity.  These types of assets are valued at the lower of cost basis or fair market value.  Given this less advantageous valuation, such gifts are limited only by the highest income limitation of 50%.
All of these different types of property, cash, works created by the donor, inventory, and short-term capital gain property, are all given the same income limitation of 50% when transferred to a public charity.  They are all treated the same because they all fall into the category of not being long-term capital gain property. 

Why is long-term capital gain property treated differently than everything else?  Gifts of long-term capital gain property come with a potential double tax advantage to the donor.  First, the donor is allowed to deduct the full fair market value of the property transferred to charity.  Second, the donor never had to pay any taxes on the appreciation (growth) of the property which generated the tax deduction.  This combination of tax advantages does not apply to gifts of other assets such as cash or ordinary income property (which is valued at the lower of its basis or fair market value).  Although the tax code allows this special benefit for gifts of long-term capital gain property, the income limitations lower the maximum amount of deductions that can be used from this type of transaction in any one year.

It might help to think of long-term capital gain property valued at fair market value as a “less-favored” asset.  When a donor gives this less-favored asset to a favored recipient (public charity), the income limitation is lowered to 30%.  The “favored” or “less-favored” terminology is not from the tax code, but may be a useful concept to help understand intuitively why the rules are as they are.  For example, in order to get the highest income limitation (50%), a donor must give a favored asset (e.g., cash or short-term capital gain property) to a favored charitable entity (e.g., a public charity).  If a donor gives a less-favored asset (long-term capital gain property valued at fair market value) to a favored charitable entity (a public charity), the income limitation is lowered to 30%.  Similarly, if a donor gives a favored asset to a less-favored charitable entity (a private foundation), the income limitation is also lowered to 30%.  And, finally, if a donor gives a less-favored asset (long-term capital gain property) to a less-favored charitable entity (a private foundation), the income limitation is lowered to 20%.  This concept reduces a range of complex rules to the simple equations of:

Favored + Favored = 50%

Favored + Less-favored = 30%

Less-favored + Less-favored = 20%

Within this context, long-term capital gain property is a less-favored asset.  But, the reason it is less-favored is because it can be deducted at fair market value.  So, in many cases where long-term capital gain property given to a public charity must be valued at cost basis, it is no longer a less-favored asset.  This means that gifts of long-term capital gain property to a public charity may be subject to either a 50% limit (usually when valued at cost basis) or a 30% limit (usually when valued at fair market value).
Consider the gift of an acre of investment land where the donor purchased the land in 1990 for $600, and today it is worth $2,800.  The gift of this land to a public charity would normally generate a charitable deduction of $2,800.  The donor receives the benefit of a large deduction and also avoids paying capital gains taxes on the $2,200 of growth.  (This is more beneficial than selling the land, paying the capital gains tax, and then transferring the net proceeds to the charity as cash.) Because the donor receives this special tax benefit, the tax code limits the amount of these deductions in any one year to 30% of the donor’s income, requiring all additional such deductions to be carried forward into future tax years.
If, however, the donor is willing to give up this special tax advantage and deduct only the basis of all long-term capital gain property gifts, then the donor is allowed to use such deductions from gifts to public charities up to 50% of his or her income.  This “special election” applies to all long-term capital gain gifts made in a year.  The donor may not select some gifts for this treatment and exclude others.  In this case, the donor would be allowed to deduct only $600 for the gift of the acre of land to a public charity, rather than $2800.  However, charitable deductions for these types of gifts to public charities could be used to reduce up to 50% of the donor’s income.  Obviously, taking this “special election” makes sense only for donors whose charitable deductions would otherwise be carried forward into future years.  It may also be particularly attractive in cases where donors are giving long-term capital gain property that has appreciated very little.

As discussed in the chapter on valuation of property gifts, tangible personal property has special rules for valuation.  Tangible personal property includes all of those items that can be seen and touched and moved, such as the items in a typical garage or home, but would not include the garage or house itself, because those are attached to the land, making them real property.

Tangible personal property does not include financial instruments such as stocks or bonds.  These are intangible personal property items.  Physically, stock or bond certificates are simply pieces of paper.  They do not have value from their physical properties, but instead have value only from their intangible legal properties.

Although tangible personal property has special rules for valuation, the general concept used with other long-term capital gain property applies here as well.  If the gift of long-term capital gain tangible personal property to a public charity is valued at its basis, the deductions can be used up to 50% of income.  If, instead, it is valued at fair market value, those deductions can be used up to 30% of income.

Suppose a donor purchased an antique toy car in 1990 for $1 and today it is worth $25.  If the donor gives the toy to a charity that will immediately sell it, the deduction for the gift will be limited to its basis, in this case $1.  The deduction is limited to basis because the charity is not using the property itself in its charitable function, but is instead selling the property, and using the proceeds.  Although the donor receives a lower deduction, these deductions may be used to reduce up to 50% of the donor’s income. 

Conversely, if the donor were to give the antique toy to a public charity that displayed it in its museum as part of its nonprofit function, then the donor could deduct the fair market value of the gift.  Thus, the donor would receive a charitable deduction of $25 rather than $1.  Along with this greater deduction, however, comes the limitation that such deductions may reduce income by no more than 30% in any one year.  (Note that this fair market value deduction is available only for long-term capital gain tangible personal property.  Short-term capital gain tangible personal property is valued at the lower of its basis or fair market value, regardless of use by the charity.)

Although the rules for long-term capital gain tangible personal property are different from those for other types of long-term capital gain property, the principle is similar.  If a donor receives the higher (fair market value) deduction valuation for a gift to a public charity, then the donor receives the lower income limitation.

As mentioned previously, 50% is the default income limitation for deductions from charitable gifts to public charities.  An exception to that rule is made for gifts of long-term capital gain which, in some cases, trigger a 30% income limitation.  There are, however, some deductible gifts which are not considered to be made “to” a public charity, but still benefit a charity.  These relatively rare transactions fall into the category of gifts made “for the use of” charity.  Gifts, even gifts of cash, made not “to” a charity but “for the use of” a charity do not qualify for the 50% income limitation, but instead qualify for a 30% income limitation.  Gifts of long-term capital gain are limited to only a 20% income limitation.

Although the general principle is that this term encompasses any money given “in trust” to another entity where the charity receives current benefits, there are really only two common scenarios where this issue arises.  The first is paying premiums directly to a life insurance company for charity owned life insurance policies.  The charity benefits from the transaction, because its life insurance policy premiums are paid.  However, the money actually goes to the life insurance company, which is not a charitable entity.  Similarly, a deductible gift can be made to a grantor Charitable Lead Trust, where the trust pays a fixed amount of the gift to a charity each year for a period of years, with the remainder going to some non-charitable beneficiary.  Again, the transfer to the Charitable Lead Trust benefits the charity, but the charity does not receive its share directly – only indirectly over time through the trust.  [Note that this issue does not relate to Charitable Remainder Trusts, because they are themselves charitable entities whereas Charitable Lead Trusts are not.]  Given that these are normally the only two applications of this special rule, it may be easier to simply note these two scenarios as exceptions rather than thinking of the general principle involved.  As discussed below, the carryover of deductions in excess of these limitations “for the use of” charities is currently uncertain.

Public charities are favored recipients in the income limitation rules.  Consequently, they have the possibility of generating deductions for which donors can receive a 50% income limitation.  In contrast, gifts to private foundations can never generate a 50% income limitation.  Private foundations are somewhat less favored by the tax law.  Typically, private foundations are family foundations that are controlled by the donor and the donor’s friends and family.  Although such private foundations do make annual distributions to public charities, they do not directly operate or manage charitable work.  Being one step removed from charitable work and typically being controlled by the donor and the donor’s family, these entities are given substantial tax benefits, but not to the same level as public charities.

The rules for income limitations for gifts to private foundations are similar to those for gifts to public charities.  Any gifts, except for long-term capital gain, qualify for the highest income limitation for private foundations, which is 30%.  Conceptually, this is a favored asset (i.e., not long-term capital gain) being given to a less-favored organization (i.e., a private foundation).  Thus, the donor receives neither the highest income limitation of 50% (reserved for favored assets going to favored organizations) nor the lowest income limitation of 20% (reserved for less-favored assets going to less-favored organizations).

Although the slides use the example of the Bill & Melinda Gates Foundation as a private non-operating foundation, donors rarely give to other people’s private foundations, but instead create their own private family foundations, which, along with their friends or family members, they typically control and manage.  Indeed, often one of the defining characteristics of a private foundation is that it does not receive substantial charitable gifts from the general public.  Instead, private foundations are typically supported predominantly by gifts from one family.

The same types of property gifts which qualified for the 50% income limitation when given to a public charity will also qualify for a 30% income limitation when given to a private foundation.  The simplest example is, of course, a gift of cash.  Gifts of cash include both cash given directly to a charity and cash spent performing services on behalf of a charity.  (There is no deduction for time and effort spent on behalf of a charity.)
Also similar to the previous rules, gifts of ordinary income property qualify for the private foundation’s highest income limitation of 30%.  Ordinary income property includes any creations by the donor.
Ordinary income property also includes any inventory given to the private foundation.  Such gifts also qualify for the highest income limitation available for gifts to private foundations of 30%.
And finally, also as before, short-term capital gain property (capital gain property held for one year or less) is treated as other forms of ordinary income property and also qualifies for the highest income limitation available for gifts to private foundations (30%).
When donors give a less-favored asset (long-term capital gain property) to a less-favored organization (private foundation), this results in the lowest income limitation for individual donors of 20%.  Note that this rule is simpler than that for public charities, because there are no exceptions that can increase the percentage, such as the “special election.”  Thus, the donor will receive the 20% income limitation, regardless of whether the long-term capital gain property was valued at fair market value (available only for “qualified stock”) or at basis.  Similarly, such gifts given “for the use of” rather than “to” a public charity (via a Charitable Lead Trust or payment of premiums on charity-owned life insurance) are have a 20% limit.
Just as the “special election” exception does not affect the income limitation for long-term capital gain property given to private foundations, so too the “unrelated use” exception for long-term capital gain tangible personal property does not affect the income limitations for gifts to private foundations.  Similarly, gifts of tangible personal property to a private foundation are valued at the lower of basis or fair market value, regardless of the “related use” issue.  In sum, the income limitation rules for gifts of long-term capital gain property are much simpler for private foundations.  In such cases, the limitation is always 20%.
The previous income limitation rules apply to charitable deductions for individual taxpayers.  Corporate giving for traditional C-corporations follows a single rule limiting deductions to 10% of taxable income.  Just as with individual taxpayers, C-corporations can also carry forward excess charitable deductions for up to five years.  S-corporations do not have separate income limitation rules, because all deductions simply pass through to become the personal deductions of the individual shareholders.
In order to receive the highest income limitation of 50%, a donor must give a public charity either something that is not long-term capital gain property, or is long-term capital gain property that is valued only at its basis and not its fair market value.  (Such lower valuation can occur through a “special election” or a gift of “unrelated” use long-term capital gain tangible personal property.)
In order to receive the middle level income limitation of 30%, a donor must either give less-favored property (long-term capital gain valued at fair market value) to a favored charitable entity (e.g., a public charity), or give favored property (not long-term capital gain) to a less-favored charitable entity (e.g., a private foundation).
Finally, in order to receive the lowest level income limitation of 20%, a donor must give less-favored property (long-term capital gain) to a less-favored charitable entity (e.g., a private foundation).
So far, the chapter has reviewed the income limitations for charitable deductions from different types of gifts to different organizations.  But, what happens when these income limitations are exceeded?
When income limitations are exceeded, the charitable deductions are not lost.  Instead, the excess deductions must be carried over to future years.  As soon as there is a year in which the income limitations are not exceeded for the type of charitable deduction carried over, those deductions may be used.  However, the deductions must be used in one of the five years following the year of the gift.  Otherwise the charitable deduction will expire.  (Regulation 1.170A-10(a)(1) and PLR 8824039 indicate that excess gifts “for the use of” charity cannot be carried forward, but IRS publication 526 and PLR 200010036 indicate that they can be.)
This chart is a visual demonstration of how unused charitable deductions may be carried forward.  In each year, the dashed line represents the charitable deduction maximum dollar amount for this type of gift.  In year one, the donor gives more than the charitable deduction maximum level.  The portion given in year one up to the income limitation is shown below the dashed line and that part may be deducted in year one.  The amount above the dashed line in year one must be carried over into future years.  In year two the donor makes additional deductible gifts (designated in dark text).  Note that gifts made during the year will be counted first, prior to counting any carryover deductions.  After counting these gifts made in year two, there is still remaining space under the income limitation maximum for year two.  Thus, part of the carryover deduction may be used in year two.  In year three, the donor makes gifts up to the maximum income limitation.  Consequently, no carryover deductions may be used in year three.  Finally, in year four the donor again makes gifts, but there is still remaining space under the income limitation maximum for that year.  Thus, the remainder of the carryover may be deducted in year four, leaving no additional carryover for future years.
When a donor has carryover charitable deductions from multiple years, the oldest carryover deductions will be used first.  This rule is advantageous to the donor because carryover deductions will expire after the fifth year following the year of the charitable gift.  So, the donor would prefer to use the oldest carryover first to reduce the risk of the charitable deduction carryover expiring.  In the example in the chart, the donor gives more than the income limitation amount in both year one and year two.  In year three, the donor gives less than the income limitation maximum, allowing for the use of carryover deductions.  The carryover deductions from year one are used in year three, and not the carryover deductions from year two, because the carryover deductions from year one are older.  In year four the donor makes gifts up to the income limitation and thus no carryover deductions may be used in that year.  Finally, in year five, the donor again gives less than the income limitation maximum, allowing the remainder of the carryover deductions from year one to be used.  After all of the year one deductions from this type of charitable gift are used, only then can the carryover deductions from year two begin to be used.
These scenarios assume that the donor uses all of the charitable deductions generated in each year.  But, what happens if a donor with carryover charitable deductions takes no itemized deductions for a year, and instead takes the standard deduction?  (Taking the standard deduction is an alternative to taking individual itemized deductions such as the charitable deduction or mortgage interest deduction.)
Even though the donor uses no itemized deductions in the year when he or she takes the standard deduction, the carryover charitable deductions will be eliminated as if the donor used as much of them as possible (i.e., up to the income limitations).  In this example, the donor made excess charitable gifts in year one, generating carryover charitable deductions.  In year two the donor made some deductible charitable gifts, but chose not to deduct those gifts in favor of taking the standard deduction.  Even though the donor does not use any of the carryover deductions in year two, these carryover deductions will be eliminated as if the donor used as much as was legally possible.  Thus, the donor will lose carryover deductions in the amount of the difference between the income limitation in year two for this type of gift and the deductible gifts made in year two.  This unpleasant result means that using the standard deduction is not an effective way of preserving carryover charitable deductions.  Next, in this example, the donor makes deductible gifts up to the income limitation for this type of gift in year three, meaning that no carryover can be used in year three.  And finally in year four the donor makes additional gifts, but not up to the maximum level, thus leaving room for the remaining carryover deductions to be used in that year.
The previous example considers how the donor can use these carryover deductions during the five years following the year of the gift.  However, what happens if the donor dies with unused carryover deductions?
The answer, unfortunately, is that carryover charitable deductions are simply lost at death.  For joint returns the amount of carryover lost is equal to the carryover that could have been claimed by the decedent, if the couple had filed separately.  Thus, when a donor makes charitable gifts in excess of the income limitations, there is a risk that those carryover deductions may not ever be used.  This could happen because the donor’s subsequent income limitations (after absorbing current giving deductions in each year) are insufficient to absorb the carryover deductions, or because the donor dies prior to using the carryover deductions.
The previous section reviewed which income limitations apply to which type of gifts.  However, it did not examine how the different limits work together.  This is a complicated but important question because a donor may be dealing with a variety of different limits that interact in different ways.  (A donor cannot, for example, deduct up to 50% of his income with one type of gift and then deduct another 30% of his income with another type of gift and then deduct the final 20% of his income with a final type of gift.)
It may be helpful to conceptualize the interaction of these rules by thinking of four different glasses.  Each glass represents a specific income limitation rule for specific types of gifts.  The question then becomes if the total of each type of gift made during a year can be “poured into” each type of glass.  The first glass can hold up to 50% of income.  All deductible charitable gifts for the entire year must be poured into this first glass.  The second glass can hold up to 30% of income.  Into this glass the donor must put all gifts of long-term capital gain (regardless of the recipient charity), excepting only capital gain for which a “special election” has been made.  The third glass can also hold up to 30% of income.  Into this third glass the donor must put all gifts to private foundations made during the year (as well as any gifts made “for the use of” public charities, usually meaning deductible gifts to a Charitable Lead Trust or to a life insurance company to pay for charity owned life insurance).  The final glass can hold only 20% of income.  Into this final glass the donor must put all gifts of long-term capital gain property made to private foundations during the year.
If the gifts of a particular type cannot all fit into the relevant glasses, there will be overflow.  This overflow represents the amount of carryover deductions that cannot be used in the current year.  Note that this spillage analogy works to calculate what deductions must be carried over.  The amount that can be deducted is the total deductible charitable gifts for the year, minus what must be carried over.  (Do not attempt to use the glass analogy to calculate the amount of deductions for a current year by thinking about how much remains in each glass, but instead focus only on the amount of overflow as representing deductible charitable gifts that must be carried forward into future years.)
As a first example, consider a donor with $100,000 of income (as before, this means adjusted gross income excluding any net operating loss carry back).  During the year, the donor has made a total of $30,000 of gifts of long-term capital gain property (valued at fair market value) to a public charity and $20,000 of cash gifts to a private foundation.  Next, consider what happens when attempting to “pour” these gifts into each glass
The first glass can hold up to 50% of income.  All gifts must be able to fit into this first glass.  In this case all gifts combined total $50,000.  50% of income also totals $50,000.  Thus, there is no spillage with the first glass and therefore no carryover resulting from the first glass.  The second glass can hold up to 30% of income.  Thus, in this case, it can hold up to $30,000.  Into this glass must be poured all gifts of long-term capital gain (except “special election” capital gain).  The donor made a total of $30,000 of such gifts during the year and so, once again, there is no spillage.  The third glass can also hold up to 30% of income.  This third glass holds all gifts to private foundations, which in this case amount to $20,000.  The $20,000 of gifts to private foundations easily fits into the $30,000 glass size and so, once again, there is no overflow.  The final glass relates to gifts of long-term capital gain to private foundations and no such gifts were made during the year.  So again, there is no spillage.
Because there was no spillage or overflow out of any of the four glasses there is no carryover.  Thus, all charitable deductions will be allowed in the current year.  (Remember that in this analogy the amount of charitable deductions allowed in the year is the total amount of deductible charitable gifts less any gifts that must be carried forward.)
The previous example did not create any carryover.  However, before looking at one of these carryover examples, it is useful to know which type of gifts gets deducted first and which type of gifts are carried forward first.  For example, if there is spillage out of the first glass into which all gifts must be poured, which gifts are carried forward?  This is an important issue because the gifts carried forward retain their original identity and consequently must, in the future year in which they are used, be able to fit into each income limitation “glass” related to that type of gift.

Add comment

Login to post comments

Comments

Group details

  • You must login in order to post into this group.

Follow

RSS

This group offers an RSS feed.
 
7520 Rates:  Aug 1.2% Jul 1.2.% Jun 1.2.%

Already a member?

Learn, Share, Gain Insight, Connect, Advance

Join Today For Free!

Join the PGDC community and…

  • Learn through thousands of pages of content, newsletters and forums
  • Share by commenting on and rating content, answering questions in the forums, and writing
  • Gain insight into other disciplines in the field
  • Connect – Interact – Grow
  • Opt-in to Include your profile in our searchable national directory. By default, your identity is protected

…Market yourself to a growing industry