By: Douglas Andre
Chief Wealth Officer & Senior Family Office Counsel of Keel Point
Many of the ultra-high net worth (“UHNW”) families that our Family Office serves are very charitably inclined. Giving to charitable organizations provides benefits to underserved communities and funds essential activities throughout the world. Charitable giving also provides opportunities for members of UHNW families to coalesce around a common purpose while instilling a greater sense of community in members of younger generations. Charitable giving also provides significant tax benefits as contributions are generally deductible for income and/or transfer (gift & estate) taxes.
This article reviews several options for structuring charitable giving programs. Choosing among these options will depend on each family’s goals and objectives including: (i) to what extent does the family wish to exert some level of control over who will ultimately benefit from their giving; (ii) the types of assets the family plans to contribute; and (iii) the specific tax attributes associated with giving structures that will most benefit the family.
Outright Gifts to Public Charities. U.S. tax laws draw a distinction between public charities and private foundations. These rules define public charities as tax-exempt organizations that generally draw their support from multiple sources (although some privately funded organizations may also qualify). Public charities include churches, schools, many hospitals and other organizations that provide support to specific causes and communities (e.g., the American Red Cross). Often a public charity will provide benefits to a wide swath of individuals depending on the organization’s specific focus.
Outright gifts to public charities comprise a significant percentage of charitable giving in the United States. While gifts of cash are likely the most common source of giving, many families derive greater tax benefits from making gifts of appreciated property (e.g., marketable securities). Gifts of appreciated property provide an enhanced tax benefit in that the donor receives a charitable income tax deduction for the full value of the property, but the unrealized gains are not taxed to the donor (as would be the case if the security was sold and the cash proceeds contributed). Upon receipt, the charitable organization may sell the property but because it is tax exempt it pays no tax on the realized gain.
Private Foundation. Private foundations are defined as tax-exempt entities that don’t qualify for public charity status. Limits applicable to income tax deductions for gifts to private foundations are less favorable meaning some gifts may not be fully deductible in the year made.1 Private foundations are also subject to a series of potential excise taxes, often referred to as the “private foundation rules.” Under these rules, taxes can apply to transactions that constitute self-dealing or when the private foundation holds concentrated positions of certain closely held companies. Private foundations generally require a formal governance structure to avoid triggering the private foundation rules. Private foundations are required to file annual tax returns.
Families that establish a private foundation can maintain close control over the investments held by the foundation. The family can also control when grants are made and the amounts and ultimate recipients of those grants. The family receives an immediate income tax deduction upon contributing assets to the private foundation, but distributions to the ultimate beneficiaries can, within certain limits,occur in later years. For families with significant charitable intent, a private foundation can provide a robust family-governed structure that carries out significant charitable giving over time. This legacy of giving can extend over multiple generations, providing opportunities for members of the older generation to instill a charitable mindset among their descendants.
Donor-Advised Fund. A donor-advised fund (“DAF”) is a separate account established and named by the UHNW family. The DAF account is maintained by a public charity – typically a community foundation that maintains numerous DAFs for individuals and families. Because the DAF is an account, the family is not required to establish a formal governance structure or file additional tax returns. This streamlined record keeping and management makes the DAF easier and less expensive to establish and manage. Because the DAF is maintained by a public charity, contributions to the DAF benefit from the higher AGI limits meaning more of the contributed amounts are immediately deductible.
A key attribute of DAFs is the family can provide recommendations to the sponsoring organization as to the amounts and timing of distributions to ultimate grant recipients. While the sponsoring organization is not required to follow the family’s grant recommendations most do if the grant recipient is a reputable charitable entity. Thus, the control over grantmaking afforded by a private foundation is, in practice, achievable at a lower cost when the family opts to use a DAF. Many families employ a grant committee comprised of members from multiple generations to make grant recommendations. Through this structure, families can establish a charitable giving legacy without the cost and administrative burden of forming a private foundation.
Split Interest Trusts. Charitable giving can also provide significant gift and estate tax savings. For example, charitable gifts made upon the death of an individual can qualify for an estate tax deduction, significantly reducing estate taxes. Two types of split interest trusts – the charitable lead trust (“CLT”) and the charitable remainder trust (“CRT”) are powerful estate planning strategies that can carry out charitable intent while reducing taxes.
A CLT is frequently included in the estate plans of UHNW individuals. At death, the donor’s estate receives an estate tax deduction upon funding a CLT. A common planning strategy is for UHNW individuals to leave a portion of their taxable estate – typically the amount in excess of the decedent’s available estate tax exemption – to a CLT which exists for a defined term (e.g., 20 years). The estate receives an estate tax deduction equal to the present value of the charitable or “lead” interest. During the CLT term, the trust makes annual distributions to charitable organizations (including, potentially a private foundation) in the form of annuity or unitrust payments. At the end of the term, the CLT terminates and whatever remains in the trust passes to the grantor’s descendants free of estate tax. Depending on the growth rate of assets held in the trust, this amount can exceed the value of contributed assets. As a CLT can be employed during life or at death, the trust provides a means to transfer assets to descendants with a significantly reduced gift or estate tax.
A CRT is a trust whereby the grantor or another family member receives an annuity or unitrust payment for a term of years (or for the beneficiary’s lifetime) after which the remainder interest passes to a named charity. A CRT can provide a lifetime income stream to the grantor and a spouse after which whatever remains in trust passes tax free to charity. The grantor receives an immediate income tax deduction upon funding the trust equal to the present value of the remainder interest. Because the CRT istax-exempt, it does not pay income tax upon the sale of appreciated assets contributed to the trust. While distributions to the family members will carry out income tax liability over time, the CRT provides significant income tax deferral. The CRT is particularly useful for families that own appreciated property like a family business where the family is contemplating selling the business.
Whether a CLT or a CRT is right for the UHNW family depends on a number of factors such as the grantor’s need for a lifetime stream of payments, whether the grantor (or the estate) would benefit from an estate tax deduction, and the prevailing interest rates when the trust is funded. These split interest trusts can be designed as annuity trusts or trusts that pay a unitrust amount. This and other options make these strategies particularly beneficial for UHNW families.
Many families with significant wealth believe that wealth carries with it an obligation to give back to the community and world. Depending on the family’s mission, vision, values and goals, tailored charitable giving strategies can be established to carry out charitable giving in a way that maximizes the benefit to both grant recipients and members of the family.
1 The tax code imposes limits on the amount of income tax deductions that can offset income in a single tax year. These limits are defined as a percentage of the donor’s adjusted gross income (“AGI”). The AGI limit for gifts to public charities is generally higher than that for donations to private foundations. Amounts that can’t be deducted in the current year can generally be carried forward and used as a charitable deduction in the five following tax years.