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Navigating Charitable Bequests: Risks and Rewards for Early Planning

August 3, 2023 Articles
Financial Advisor

Charitable bequests are an essential aspect of philanthropic planning for high-net-worth individuals. When engaging in conversations with philanthropic clients, it is crucial to assist them in determining suitable assets for charitable giving. Not all assets are equally suitable for donation, and some can present challenges for charities. This article aims to provide insights into asset selection, considerations for charitable beneficiaries, and potential pitfalls to be aware of when making charitable bequests.

Choosing Suitable Assets for Charitable Giving

During discussions with clients, it is important to assess a client’s asset mix and identify assets that are attractive for charitable giving. Key considerations when donating assets to charity include whether assets can be transferred and liquidated, how long that process will take, and the ability to value the asset through a qualified appraisal. Low basis assets, which have built-in capital gains, are particularly beneficial for both the donor and the charity. By donating assets with built-in capital gain, donors can claim a tax deduction while allowing charities to receive the proceeds without recognizing capital gains upon sale. Assets that are easily marketable and liquid, such as retirement accounts, are also favorable options for charitable giving. While non- cash contributions can sometimes be complicated for charities, a contribution of cash to a charity does not offer the donor the most bang for the donor’s buck.

Assets with built-in gain for income tax purposes compound the benefit to the donor because the donation of such built-in gain assets allows the donor to avoid paying a capital gains tax on the assets. For instance, assume donor contributed marketable securities with a fair market value of $10,000 to a public charity. Now, assume the donor held the marketable securities for more than one year and the donor’s income tax basis in the marketable securities was $2,500. The donor has a built-in long-term capital gain of $7,500 in the marketable securities. This means, if the donor were to sell the securities (rather than donate them), the donor would owe a long-term capital gains tax on the $7,500 net proceeds from the sale (i.e., the $10,000 fair market value less the $2,500 which is the donor’s basis). Assuming a federal capital gains tax rate of 20%, the income tax due on the $7,500 net proceeds equals $1,500. If the donor sold the securities and then donated the net proceeds to charity, the donor would pay the IRS $1,500 in taxes on the sale of securities and the donor would contribute the balance of the net proceeds in the amount of $8,500 (i.e., $10,000 less the $1,500 capital gains tax paid) to charity. In this case, the donor would receive an income tax deduction for $8,500 (i.e., the amount donated to charity). Thus, at the end of the transaction, the charity received $8,500, the IRS received $1,500 and the donor got a tax deduction for $8,500. On the other hand, if the donor directly contributed the securities to charity, the charity would receive $10,000 worth of marketable securities and the donor would receive a charitable tax deduction for $10,000. The charity would then sell the securities for $10,000 and it would not have to pay any income tax on the sale (due to its charitable status). Thus, at the end of the transaction, the charity received $10,000 worth of securities, which it immediately sold for $10,000, the IRS received $0 and the donor got a tax deduction for $10,000.

Determining the Split Between Taxable Beneficiaries and Charity

The decision to allocate assets between taxable beneficiaries and charitable organizations depends on the client's preferences and overall estate planning goals. Some clients choose to allocate assets equal in value to the federal estate tax exemption amount (currently, $12.92M per person) to family and/or friends, with any amount exceeding the federal estate tax exemption to pass to charity. It is generally recommended that clients identify and vet specific assets intended for charity, and through that process, determine the charity's willingness and ability to accept such assets. Alternatively, as part of the estate planning process, clients can provide trustees with the discretion to determine which assets and in what amount shall pass to charity.

Flexibility in Trustee Discretion and Communication

Granting trustees substantial latitude in asset selection for charitable purposes is advisable, especially considering the

uncertainties surrounding future circumstances, such as federal estate tax exemption levels, political and economic climates, and asset values. Choosing trustworthy individuals or institutions as trustees and engaging in open discussions regarding the client's objectives can help ensure that the trustee's decisions align with the donor's intentions. It may also be beneficial to leave informal writings alongside the estate planning documents to provide insights into the donor's thoughts and preferences.

Specific vs. Flexible Charitable Beneficiaries

Clients have the option to name specific charitable beneficiaries or grant trustees the authority to choose charities. Specificity is recommended when naming charities. For instance, when naming specific charities, we recommend including accurate identifying information such as a charity’s tax identification number and verifying the correct legal name. That said, the donor may always leave the selection of charities to the trustee's discretion and direct that the trustee choose one or more charities which align with the donor’s lifetime philanthropic gifting. Clients can maintain records of their lifetime charitable gifts, which would aid the trustee in identifying institutions that align with the donor's giving goals.

Establishing Private Foundations in Estate Planning

Private foundations can be set up either during a client's lifetime or as part of the testamentary estate planning process. Although there are advantages to establishing a foundation during life, it is possible to create one as part of the post-mortem administration. Careful consideration should be given to the legal and administrative requirements involved in establishing a private foundation, especially if it involves family members and potential self-dealing issues.

Addressing Challenges and Pitfalls

Several challenges and pitfalls should be considered when making charitable bequests. These include potential valuation discrepancies that can arise when specific conditions or restrictions are attached to charitable gifts. The appraisal process plays a crucial role in accurately valuing assets for both for estate tax purposes and charitable tax deductions. Additionally, when family businesses are involved, self-dealing issues and the possibility of unrelated business income tax should be carefully addressed. Illiquid assets and fractional interest gifts can also pose challenges for charities, necessitating backup plans and open communication among beneficiaries.

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