The giving season: Understanding the universe of charitable vehicles

The final quarter of the year is the busiest season for investors when it comes to fundraising and charitable giving. Successful philanthropy depends entirely on the goal or goals an investor is trying to achieve, whether they’re social goals, wealth transfer goals, personal goals, or tax deductibility.

In this article – the first in a series on philanthropic giving – we discuss the various types of charitable vehicles that may be used to maximize philanthropic success.

While this educational piece is not intended to provide tax or legal advice, it can help investors better prepare for the wealth transfer issues and decisions commonly faced by high-net-worth and ultra-high-net-worth families.

Last year, total estimated charitable giving in the U.S. topped $557 billion. Nonprofits generate the majority of donations from four giving sources: lifetime gifts from individuals, bequests from individuals in wills and trusts, gifts from charitable foundations, and gifts from corporations. Although the largest contribution comes from individual lifetime gifts (67% of total contributions), the most successful nonprofits draw from each of these sources for the most stable year-to-year funding.¹

Before we go into the strategic aspects of philanthropy, I thought it would be helpful to define some of the commonly used terms in the world of charitable giving – specifically, the different terms for charitable organizations that are often used interchangeably but in fact have different definitions.

Nonprofit: An organization established to serve the public good, such as feeding the hungry or providing disaster relief. Nonprofits are not subject to federal income tax.

Charity: A type of nonprofit organization with a focus on providing aid to those in need. All charities are nonprofits, but not all nonprofits are charities. Charities are not subject to federal income tax, and donations are tax-deductible.

Not-for-profit: An organization established to serve the interests of the organization’s own shareholders or members, such as a sports club or trade association. Essentially, a not-for-profit is a nonprofit that is not a charity. These entities are not subject to income tax, but donations are not tax-deductible.

501(c)(3) Organizations: These are essentially the same as charities. 501(c)(3) is the section of the Internal Revenue Code (IRC) that allows exemption of an organization from federal income taxes and the deductibility of donations. Note that the IRC grants a federal tax exemption to 32 different types of nonprofit organizations (see IRS publication 557), but only gifts to 501(c)(3) organizations provide tax deductibility of donors’ gifts.

These differences are important to understand because, while most nonprofits are tax-exempt, only charities that meet specific requirements set out by the IRC can offer donors the ability to deduct contributions from income. That is why it’s critical to confirm the recipient organization’s standing regarding tax deductibility of donations. Donors looking to achieve a tax deduction should first confirm the ability of the taxpayer to itemize deductions, and second, confirm the tax-exempt status of the recipient. This information can be found through the Internal Revenue Services’ exempt organization search function, at IRS.gov. Next, let’s look at the “why” behind charitable giving and how it is often combined with other tax and wealth transfer objectives. Social goals, wealth transfer goals, personal goals, and tax deductibility all factor into the final selection of the gifting tool used for the donation. Clarifying the investor’s true motivators is an essential step in successful charitable giving.

Philanthropic investors should consider the following:

1. What social goals am I trying to achieve by making a gift?
2. What is my overall estate plan, and how does this charitable gift further my wealth transfer goals?
3. How important are tax benefits to me? What about income tax, gift, and estate tax deductibility?
4. What personal benefits am I trying to achieve? (i.e., personal satisfaction/appreciation, an initial approach to family governance, qualification for a premium or benefit in return for my contribution).

Finally, let’s explore several techniques used for charitable giving and the most common reasons for their use.

Direct cash donations: Provides maximum value and immediate liquidity for the charity. Often the easiest but not the most tax-efficient of gifting techniques.

Donations of appreciated assets held one year or less: Deduction allowed for basis or acquisition value of asset. No recognition of gain, but no deduction for that gain.

Donations of appreciated assets held more than one year: Deduction for current value of asset. No recognition of gain and therefore no tax on that gain (win, win).

Donations of assets that have unrealized capital losses (worth less now than when acquired): It is typically best to sell the asset, realize the deductible loss, and then contribute the sales proceeds.

Gifts “with benefits”: For donors who wish to receive a premium, access, or naming rights on a building or program. This can help accomplish personal goals but may reduce deductibility.

Qualified Charitable Distributions (QCDs): Properly orchestrated direct distributions from IRAs satisfy required minimum distribution limits and shield QCDs from income. QCD contributions are allowed up to $105,000 in 2024 and are indexed for inflation thereafter. QCDs are used when required minimum distributions are not needed/wanted for personal use and the client is charitably inclined.

Charitable Gift Annuities: The recipient charity receives a donation and in return agrees to provide a series of payments back to the donor. Frequently, the charity uses a portion of the gift to purchase a commercial annuity to provide the series of payments. Charitable gift annuities are typically used to ensure lifetime cash flow to the donor and may also reduce the deductibility of the contribution.

Charitable Remainder Trusts (CRTs): A CRT is similar to a charitable annuity, except the recipient of the donation is an irrevocable trust. The terms of the trust provide an income stream of payments to the donor for a number of years (not to exceed 20) or for the life of the donor (i.e., the “lead beneficiary”). At the end of the payment term, the remaining trust assets go to charity (i.e., the “remainder beneficiary”).

CRTs are commonly used to achieve income tax benefits for clients who are charitably inclined, have highly appreciated assets, would like to sell to diversify and/or create liquidity, and wish to achieve income tax deferral on the gain. Property with unrealized capital gains is contributed to the trust. The trustee then sells the property and invests the proceeds. Because the trust is irrevocable and the remainder beneficiary is tax exempt, no immediate income tax liability results from the sale, although each payment from the trust to the donor carries an obligation to pay income tax on the amount of the distribution. Thus, a CRT is a charitable contribution that comes with income tax benefits.

Charitable Lead Trusts (CLTs): A CLT is best described as the mirror image of a CRT. CLTs are irrevocable trusts whose terms provide an income stream of payments to a charity (i.e., the “lead beneficiary”) for any number of years. At the end of the payment term, the remaining trust assets go to the individual(s) designated in the trust (i.e., the “remainder beneficiaries). CLTs are used to delay and decrease the value (and gift tax) of the gift to the individual remainder beneficiaries. CLTs are frequently used to accomplish charitable goals while potentially transferring appreciating assets to subsequent generations. Thus, whereas a CRT offers income tax benefits, a CLT is a charitable contribution that comes with gift tax benefits.

Donor Advised Funds (DAFs): DAFs are charitable accounts funded by individual donors but maintained and operated by a charity. Once the donor makes the contribution, the sponsoring charity has total control over the funds. The charity is responsible for maintaining the account, investing account contributions, and distributing the account funds with the advice of the donor. Distributions are made whenever the charity and the donor direct. The law currently does not require DAF funds to be deployed. DAFs are treated as public charities for tax-deduction purposes; however, DAFs are not a qualified recipient of a QCD.

Private Foundations (PFs): Entities established by an individual, family, or corporation to support charitable activities are treated for income tax purposes as private foundations. PFs can be organized as either a corporation or a trust. They are typically used to make grants to other charitable organizations (rather than directly operate the social programs themselves).

There are many restrictions imposed on PFs, including restrictions on self-dealing and annual distribution requirements. PFs also pay tax on net investment income earned on retained assets. Contributions to PFs may provide some tax deductibility, but it is less deductible than gifts to public charities. However, PFs allow donor control of the investment of donated assets (with some limitations) and allow the donor to control the management and distribution of fund assets (with some limitations). PFs often employ and pay family members to administer the foundation.

Investors clearly have many choices when making charitable gifts, and the list of techniques above is by no means exhaustive. Clarifying and prioritizing a client’s true goals is an essential step in successful charitable giving. Additionally, working with a client’s attorney and tax professional will greatly increase the chances for success.

In the next article in our charitable giving series, I’ll explore the question: “What should I give?”

 

¹ Giving USA 2024: The Annual Report on Philanthropy for the Year 2023.

The information contained herein is for educational purposes only and should not be construed as financial, legal or tax advice. Circumstances may change over time so it may be appropriate to evaluate strategy with the assistance of a financial professional. Federal and state laws and regulations are complex and subject to change. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of the information provided. Janus Henderson does not have information related to and does not review or verify particular financial or tax situations, and is not liable for use of, or any position taken in reliance on, such information.