Easy Charitable Contribution Techniques to Reduce Your Tax Burden

August 24, 2006

Published in the AICPA's Wealth Management Insider

Donor Advised Funds and Charitable Gift Annuities are two easy ways to make charitable contributions and pay less income tax.

You're meeting with one of your favorite, long-time clients and they announce that they are going to receive an unexpected, and quite delightful, bonus this year. On learning that a large portion of the bonus will be paid to the government in the form of increased income taxes, your client laments, "I hate paying taxes!"

Your mind starts spinning with intriguing ideas to generate an income tax deduction for her, including gifts to charity, but there's a small problem. Your client is not someone with a large net worth. You know the client is charitably inclined, but probably doesn't want to deal with the expense and complexity of establishing a charitable remainder trust, a charitable annuity trust or a charitable lead trust -- and the client is definitely not a candidate for a private foundation.

Here are two ideas that might be just right:

1. Donor Advised Fund.

Why not introduce the idea of a donor advised fund at your local community foundation? Your client could contribute cash or appreciated assets to create a fund, named after your client or in honor of someone he or she selects, which would be managed by the community foundation. Your client would serve as "advisor" for the fund, suggesting what contributions should be made, and in what amounts, to selected charities. Of course, the other good news is that your client will get an income tax deduction for the contribution, subject to the limitations on the use of that deduction, of which you are aware.

- The satisfaction of the gift. Your client may get tremendous satisfaction from creating such a donor advised fund. Even though the contributed amount may be fairly modest, let's say $10,000, your client can establish a donor advised fund at a local community foundation, which could be named after your client or someone else the client chooses. Your client will most probably be shown on every list of donors published by the community foundation. And the community foundation might just feature your client in a nice article in their next newsletter. It doesn't hurt to ask!

Your client may also enjoy the sense of involvement when they create a donor advised fund. Your client will meet with the community foundation on a regular basis to review his or her fund's market performance and to gather information from the community foundation on various local or national charities. He or she may be invited to hobnob with other contributors at community foundation social functions. Your client can be as proactive or as passive as wanted with respect to selecting the charities that will receive gifts from the client's fund. It will be up to your client to select charities on an annual basis, changing them from time to time. Or, your client may simply want to give the community foundation a broad direction to make gifts from his or her fund to certain types of charities, allowing the community foundation to make the final decisions for the gifts.

- A teaching opportunity. A donor advised fund may also be a wonderful vehicle for your client to teach the virtues of charitable giving to the younger generations in her family. Let's say your client is single, and has five teenage nieces and nephews. The nieces and nephews can be named to join as advisors for the client's fund. Each year, the nieces and nephews can be asked to select one or more charities to receive distributions from the fund. Then your client would ask the group to monitor how the gift was used after it was received. The next year, the group reports back on the prior year's gift and discuss whether the same charity, or a different charity, should receive the next gift. Your client could also name nieces and nephews to serve as advisors to the fund when the client is no longer capable of doing so.

- Investment management. Your client doesn't have to worry about how to invest the assets held in the donor advised fund. The community foundation will do it for in return for an annual fee.

Once the Donor Advised Fund is established, your client can add to the fund over time. Your client may do so during his or her lifetime and upon the client's death, with each contribution creating an income or estate tax deduction, as the case may be.

2. Charitable Gift Annuity.

Another easy way for your client to make a charitable contribution is through a charitable gift annuity.

A gift annuity, in general terms, involves a contribution to a charity, in return for which your client, or someone else of your client's choosing, receives an annual payment. A gift annuity is a very simple, straightforward way to make a contribution to a favorite charity, and to retain a stream of payments, without needing to engage an attorney to draft a set of complicated documents.
In reality, a gift annuity is part gift to charity, and part purchase of an annuity in favor of your client or someone else she selects. For purposes of this discussion, we'll assume that your client reserves the annuity payments for him or herself, and that your client doesn't give the annuity payments to anyone else.

- Find the charity first. Here, your client must first find an established charity that offers gift annuities to its donors. Usually, regional hospitals, colleges and universities, and certain other large charitable organizations will offer gift annuities to donors. This illustrates the first major difference between the donor advised fund and the gift annuity, which is the timing of the selection of the charity. With the donor advised fund, your client may select a wide range of charities to receive distributions from her fund, changing them from time to time for as long as the fund is in existence. On the other hand, if your client uses a gift annuity, he or she will be selecting the charity up front, and that charity will receive the entire charitable benefit from his or her contribution.

- Calculating the annuity payment. Another difference between a donor advised fund and a gift annuity is the return your client will receive. Your client receives no payments back from the community foundation if he or she creates a donor advised fund. On the other hand, with a gift annuity your client will receive an annual payment from the charity.

How much does your client get? Let's say your client, age 55, contributes $100,000 to her university in return for a gift annuity. The university, in a standard contract, will announce what percentage of the $100,000 contribution your client will receive back each year. If the university uses the annuity rates suggested by the American Council on Gift Annuities (as most major charities do), the annuity for a gift made in 2006 by a 55-year old would be 5.5 percent of $100,000 each year, or $5,500. The annuity payment won't increase or decrease over time, so your client knows exactly what he or she will receive each year, and will never receive more than that amount.

Often, the annuity rates that apply to gift annuities (such as the American Council on Gift Annuities' current rates of 5.5 percent for a 55-year old, 7.1 percent for a 75-year old, or 8.5 percent for an 82-year old) are higher than your client could earn on funds held in a savings account, CD or conservative mutual fund. Your client should always remember, though, that they have given the principal away to the charity, and they cannot retrieve it if it is needed later.

Tax consequences

There are several tax consequences of a gift annuity. First, your client will be entitled to an income tax deduction equal to the difference between the contributed amount and the present value of the annuity that she will receive. Of course, the amount of the deduction that she may actually use is dependent upon certain restrictions or limitations, all known to you as the client's tax advisor. Also, the annuity payments that your client receives will be subject to income tax, taking into account that a portion of the annuity payments are considered tax-free returns of the contribution. Last, if your client used appreciated assets to make the contribution, the purchase of the annuity is considered a sale of the appreciated property for less than fair market value, and it is therefore subject to the bargain sale rules. Any gain recognized as a result will be reported on a pro rata basis over your client's lifetime, as they receive their annuity payments.

Conclusion

While both of these techniques are fairly straightforward, there are more details to explore, and other tax and legal consequences that must be discussed before she makes her final decision to proceed. You may want to arrange one or more meetings for your client with the community foundation or charity that will be involved in the gift, to gather all of the information your client needs to make her decision.

But if your client uses one of these techniques and she's happy with it, both for tax and for charitable reasons, you could be a hero!