Charitable Deduction Strategy Cuts Tax Bill by $42,000
Executive Summary
A high-net-worth client with a strong philanthropic inclination was leaving significant tax savings on the table due to an inefficient charitable giving strategy. Benjamin Chow at Pacific Gate Capital recognized this opportunity and developed a comprehensive plan leveraging appreciated securities and a donor-advised fund (DAF). By implementing this strategy, the client not only supported their chosen charities but also reduced their federal tax liability by $42,000 in the first year.
The Challenge
Our client, a successful entrepreneur in the tech industry, consistently donated approximately $100,000 annually to various charitable organizations. While their generosity was commendable, their approach was unsystematic and failed to capitalize on available tax benefits. Specifically, they were primarily donating cash, which, while beneficial to the charities, provided limited tax advantages compared to other methods.
For instance, in the previous tax year, the client earned a taxable income of $850,000. They donated $100,000 in cash and took the standard deduction (assuming they were unable to itemize above the standard deduction threshold). This resulted in a taxable income of $750,000, and a corresponding tax liability based on the applicable tax bracket.
Furthermore, the client held a significant portfolio of publicly traded stocks, many of which had appreciated substantially in value since their initial purchase. Selling these assets directly would trigger capital gains taxes, further diminishing their after-tax investment returns. These unrealized gains represented a missed opportunity to benefit both the client and their chosen charities. We estimated they were losing approximately $10,000 - $15,000 in potential tax savings annually by not optimizing their charitable giving. The lack of a structured approach also made it difficult to track donations, manage receipts, and efficiently allocate funds across different causes. Without a strategic plan, the client was essentially donating the same amount but receiving significantly less in tax benefits.
The Approach
To address the client's challenges, Benjamin Chow developed a tailored charitable giving strategy centered around two key components: donating appreciated securities and establishing a donor-advised fund (DAF).
1. Appreciated Securities:
The core of the strategy involved donating appreciated stocks held for more than one year directly to charity. By donating these assets instead of selling them and then donating cash, the client could avoid paying capital gains taxes on the appreciation. This provided a double benefit: the charity received the full value of the asset, and the client avoided a potentially significant tax bill.
We carefully evaluated the client's stock portfolio to identify securities with substantial unrealized gains and aligned them with the client’s philanthropic goals. The selection process focused on assets with a low cost basis relative to their current market value, maximizing the tax savings potential.
2. Donor-Advised Fund (DAF):
We recommended establishing a DAF with a reputable financial institution. A DAF is a charitable giving vehicle that allows donors to make a contribution, receive an immediate tax deduction (subject to IRS limitations), and then recommend grants to qualified charities over time. This provides flexibility in managing charitable giving and allows for strategic planning.
The DAF offered several advantages for the client:
- Immediate Tax Deduction: The client could contribute appreciated securities or cash to the DAF and receive an immediate tax deduction in the year of the contribution.
- Tax-Free Growth: The assets within the DAF grow tax-free, allowing for further appreciation before being distributed to charities.
- Flexibility: The client could recommend grants to charities at their own pace, allowing for thoughtful allocation of funds over time.
- Simplified Administration: The DAF provider handles all administrative tasks, such as processing donations, tracking grants, and providing tax receipts.
- Bunching Strategy: We recommended a "bunching" strategy, where the client would contribute multiple years' worth of charitable donations into the DAF in a single year to exceed the standard deduction threshold and itemize their deductions. This allows for a larger tax benefit in the year of contribution while still supporting charities consistently over time.
We emphasized the importance of coordinating with the client's tax advisor to ensure the strategy aligned with their overall financial plan and complied with all IRS regulations.
Technical Implementation
The implementation involved several technical steps and careful coordination:
1. Asset Evaluation:
We analyzed the client's investment portfolio to identify suitable appreciated securities for donation. We focused on stocks held for more than one year to qualify for long-term capital gains tax treatment. We calculated the unrealized gain on each asset and projected the potential tax savings from donating them directly.
2. DAF Establishment:
We assisted the client in establishing a DAF with Fidelity Charitable, a well-regarded and reputable provider. We completed the necessary paperwork and transferred the selected appreciated securities into the DAF account. The transfer was executed electronically to ensure efficiency and security.
3. Charitable Research:
Using Guidestar (www.guidestar.org), we thoroughly researched the client's preferred charities to confirm their 501(c)(3) status and ensure they were eligible to receive grants from the DAF. We also reviewed their financial statements and program effectiveness to ensure the client's donations would be used effectively.
4. Donation Coordination:
We worked with the client to determine the appropriate allocation of funds to each charity. We then submitted grant recommendations to the DAF provider, who processed the grants and distributed the funds to the designated organizations. We ensured that all donations were properly documented for tax purposes.
5. Tax Optimization:
We collaborated with the client's tax advisor to maximize the tax benefits of the charitable giving strategy. This involved calculating the optimal amount to donate each year, considering the client's income, deductions, and tax bracket. We also ensured that the client complied with all IRS regulations regarding charitable contributions.
Specifically, the calculations involved:
- Determining the fair market value of the donated securities at the time of donation.
- Calculating the capital gains tax that would have been owed if the securities were sold.
- Calculating the client's itemized deductions, including the charitable donation, and comparing them to the standard deduction.
- Projecting the client's tax liability before and after implementing the charitable giving strategy.
Example:
Let's say the client donated $75,000 worth of appreciated stock with a cost basis of $25,000. The unrealized gain would be $50,000. By donating the stock directly, the client avoided paying capital gains tax on this $50,000 gain. Assuming a federal capital gains tax rate of 15%, this resulted in a tax savings of $7,500 ($50,000 x 0.15).
Results & ROI
The implementation of the charitable giving strategy yielded significant financial benefits for the client:
- Tax Reduction: The client's federal income tax liability was reduced by $42,000 in the first year. This was primarily due to the avoidance of capital gains taxes on the donated securities and the increased itemized deductions from the DAF contribution.
- Increased Charitable Giving: The client was able to donate more to their favorite charities without increasing their out-of-pocket expenses. This was due to the tax savings generated by the strategy.
- Simplified Administration: The DAF provided a centralized platform for managing charitable giving, simplifying the administrative burden and improving record-keeping.
- Investment Growth: The assets within the DAF grew tax-free, allowing for further appreciation before being distributed to charities.
Before Implementation (Cash Donations):
- Taxable Income: $850,000
- Cash Donations: $100,000
- Itemized Deductions (Assuming Standard Deduction): $13,850 (2023 Single Filer)
- Tax Liability: (Based on $836,150 taxable income) = Approximately $244,000 (estimated based on 2023 tax brackets)
After Implementation (Appreciated Securities & DAF):
- Taxable Income: $850,000
- DAF Contribution (Appreciated Securities): $100,000
- Capital Gains Tax Avoided: $7,500 (See example calculation in technical implementation)
- Itemized Deductions: $100,000 (DAF Contribution) + Other Itemized Deductions (Exceeding Standard Deduction) = Approximately $110,000
- Tax Liability: (Based on $740,000 taxable income) = Approximately $202,000 (estimated based on 2023 tax brackets)
Net Tax Savings: $244,000 - $202,000 = $42,000
This represents a substantial return on investment for the client, allowing them to maximize their charitable impact while minimizing their tax burden.
Key Takeaways
Here are some actionable insights for other advisors:
- Proactively Identify Opportunities: Engage clients in conversations about their philanthropic goals and assess whether their current charitable giving strategies are tax-efficient.
- Educate Clients on the Benefits of Appreciated Securities: Explain the tax advantages of donating appreciated assets directly to charity, including the avoidance of capital gains taxes.
- Consider Donor-Advised Funds: Evaluate whether a DAF is the right fit for your clients, considering their giving patterns, administrative preferences, and tax planning goals.
- Coordinate with Tax Professionals: Collaborate with your clients' tax advisors to ensure the charitable giving strategy aligns with their overall financial plan and complies with all relevant regulations.
- Utilize Bunching Strategies: When appropriate, advise clients on the advantages of "bunching" charitable contributions to maximize itemized deductions in specific years.
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