Gift Planning Tips

April 15: It’s Not the Only Tax Deadline to Remember

Advisers should determine, when reviewing clients’ 2017 income taxes, whether clients have paid in enough in withholding or timely estimated payments to avoid penalties for underpayment of taxes during the year.  The IRS reports that about 10 million taxpayers each year are subject to the penalty.  Code §6654 requires that taxpayers pay in at least 90% of their tax liability for the current year.

A safe harbor provision allows taxpayers to instead pay in 100% of the prior year’s tax liability (110% if the taxpayer’s 2016 adjusted gross income exceeded $150,000), which may be an easier amount to compute for those whose income fluctuates from year to year.  It may be too late in the year to avoid the penalty for 2017 if a client with no earned income has failed to make timely estimated tax payments, since overpaying in one quarter (due April 15, June 15, September 15 and January 15 of the following year) does not make up for underpaying in a prior quarter.  Clients with earned income may be able to boost withholding from wages at the end of the year, since withholding is considered to be paid ratably throughout the year.  For clients who have been subject to the underwithholding penalty in prior years, it’s especially important to review withholding and estimated payments early in 2018, particularly if tax rates change.

On the other end of the spectrum, clients who receive large refunds every year may want to reduce their withholding or estimated payments to avoid giving the IRS an interest-free loan.

If Itemized Deductions Are Cut Back

Currently, about 30% of taxpayers itemize their deductions, but proposals being considered in Congress might reduce that to only about 5%.  Even though the charitable deduction appears safe, a large boost in the standard deduction could cut the ranks of those who benefit from their generosity.  But the lack of a charitable deduction doesn’t mean there aren’t still tax benefits to be received from gifts to charity.

Qualified charitable distributions (QCD) — Clients age 70½ or older can make their charitable gifts from their IRAs and avoid the income tax that would otherwise be due on withdrawals.  Although no charitable deduction is allowed, there are tax savings to the extent that the QCD takes the place of the client’s required minimum distribution for the year.  Donors may direct IRA custodians to make gifts up to $100,000 annually directly to charity.

Charitable gift annuities — Gift annuities offer donors the advantage of tax-free income, especially when funded with cash, in addition to generous yields.  A 70-year-old donor, for example, would be entitled to a 5.1% payout — far in excess of what’s generally available for CD rates or interest-bearing accounts.  (Note: A gift annuity, in contrast to a CD or savings account, is an irrevocable gift.)  However, if the donor uses the lowest §7520 rate available when valuing the gift, the tax-free portion will increase.  For example, the 70-year-old donor funding a $10,000 gift annuity providing quarterly payments would be entitled to total annual payments of $510, of which $377 would be tax-free for the donor’s life expectancy using a §7520 rate of 2.2%.  Considering the value of the tax-free income, the donor is receiving the equivalent of a 6.47% payout in a 28% tax bracket ($377÷1-.28 = $524 + $123 fully taxable = $647).  Using a 2.4% §7520 rate, the tax-free portion drops to $371.

Charitable remainder trusts — One attractive feature of charitable remainder trusts is the ability to turn a low-yielding, highly appreciated investment into higher income, without losing any of the principal to capital gains taxes.  For nonitemizers, the trust offers a way to increase spendable income without paying capital gains tax.

Using Closely Held Stock in Charitable Lead Trusts

Unlike charitable remainder trusts, lead trusts are not tax-exempt entities, so capital gains are not avoided if the plan is to redeem closely held shares after transferring them to an inter vivos lead trust.  However, leaving closely held shares to a testamentary lead trust poses no such problem, since the stock receives a step-up in basis.

What if a lifetime charitable lead trust retains the stock?  Retention works in the unusual case that the stock pays regular dividends and, if that’s the case, significant gift tax savings may be available.  Retention also may work where the trust is structured as a grantor trust intended to provide the donor with both income tax and gift tax deductions.  The plan would involve the business owner transferring stock to a lead annuity trust or unitrust that pays income to charity, with the remainder to the donor’s children.  Stock is divided into two gifts — one charitable and one private — for transfer tax purposes, and the gift tax charitable deduction reduces the taxable gift to the children.  Furthermore, some or all of the future appreciation can pass to the children free of federal transfer tax (note that capital gains taxes are still a problem when the children sell).  Under Code §4947(b)(3)(A), the value of a gift to charity cannot exceed 60% of the value of the stock placed in trust.

Encouraging Younger Family Members to Save

Clients who take advantage of the $14,000 gift tax annual exclusion [Code §2503(b)] to make tax-free gifts to children and grandchildren (increasing to $15,000 in 2018) may want to encourage the use of some of these funds to establish IRAs.  Consider a grandfather who makes annual gifts of $10,000 each to his three teenage grandchildren, all of whom have part-time and summer employment.  If $5,000 is contributed to a grandchild’s IRA every year for five years — starting when the grandchild is age 16 — the balance in the account would grow to $29,875 (assuming 6% interest) by the end of the fifth year.  By the time the grandchild is ready to retire at age 67, the account will have grown to more than $400,000, even if no further contributions are made.  But if the grandchild continues making $5,000 contributions annually until retirement, the account could grow to more than $1.5 million.  A note of caution: In our example, the grandchild must have at least $5,000 of earned income in any year during which a $5,000 contribution is made (Code §408).

A Roth IRA is another alternative, particularly since the grandchild is unlikely to need the deduction offered by a traditional IRA.  Generally, a Roth IRA must be held for five years before withdrawals are tax free, otherwise the earnings on the contributions would be subject to tax. On exception would allow the grandchild to withdraw up to $10,000 tax-free for the purchase of a first home.


Copyright © R&R Newkirk. All rights reserved.