6. Income Limitations on Charitable Deductions, Part 1 of 3

6. Income Limitations on Charitable Deductions, Part 1 of 3

Article posted in General on 4 November 2015| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 5 November 2015

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.


Links to previous sections of book are found at the end of each section.

This chapter will review income limits on charitable deductions.  This is, unfortunately, a potentially confusing and challenging area of gift planning.  There are a variety of different limitations on charitable deductions, depending upon the nature of the gift and the recipient.  Even more complex are the rules for how these different limitations interact in the current and future years.  As much as possible, this chapter will attempt to simplify, summarize, and visualize these rules in a way that makes them as understandable as possible.  Nevertheless, the reader must recognize that this is a difficult area of charitable tax law and it understanding may require some effort.
Why is all of this effort justified?  Very little wealth in this country is held in the form of cash or cash equivalents like checking accounts, savings accounts, or money market accounts.  If an advisor or fundraiser wants to be involved with large charitable transactions, he or she must understand how to work with gifts of assets rather than just working with cash.  These income limitations rules are particularly critical issues for gifts of assets.  A fundamental expectation for any advisor or fundraiser who is going to suggest the charitable transfer of an asset is, at the very least, to understand what charitable deduction that transfer will generate.  The first step in that process is to understand how the asset will be valued for purposes of the charitable deduction.  (That topic is covered in the chapter on valuation of charitable gifts of property.) The second step in that process is to understand when those charitable deductions can be used, when they must be carried forward into the future years, and when they may be lost altogether.  (This is the topic of the current chapter.) Although the process of understanding the rules for both steps can be a real challenge, this understanding is a clear prerequisite to intelligently recommending substantial gifts of assets.  It is simply not appropriate to recommend a gift of substantial assets while having no understanding of the charitable deductions that will be generated or whether or not those deductions can even be used.  The fundamental importance of this understanding as a prerequisite to encouraging large gifts of assets justifies learning the rules on income limitations for charitable deductions.
Beginning with the fundamentals, people in the United States usually pay taxes on income.  People pay these taxes to the federal government.  In most states, people also pay additional income taxes to the state government.
The next fundamental reality is that charitable gifts can sometimes be deducted from income.  These deductions are valuable to the extent that they reduce the taxes owed.  Consequently, to recommend a charitable transfer, it is essential to have an understanding of the deductions that will be created as a result of those transfers.
What is less well known is that charitable deductions may not be used to eliminate 100% of a person’s taxable income.  The total share of income that can be eliminated through charitable deductions in any one year may be 20%, 30%, or 50%, depending on the nature of the gift and the nature of the charitable recipient.  Charitable deductions beyond these limitations cannot be used in the current year, but instead must be carried forward into future years.  If the charitable deduction cannot be used within the following five years, it will expire.  Consequently, it is possible for large charitable transactions to generate large charitable deductions that have absolutely no value because the income limitations are otherwise exceeded in the current and carry-forward years.  Because advising a donor about a large charitable gift without understanding when that gift will generate no (or limited) useable charitable tax deductions is inappropriate, it is important to understand these income limitation rules.
Why should these income limitation rules exist?  It would certainly be possible to have a tax code that placed no limitations on the total amount of charitable deductions that could be used in any year.  The law could allow for donors to deduct up to 100% of their income.  But it does not.  Why not?
Encouraging charitable gifts is an important government policy objective, but it is not the only objective.  If the law placed no limitations on the amount of charitable deductions, this could reduce the funds available for traditional government functions below an appropriate level.  Charitable giving is useful, but at least some money must go to the government in taxes.  The income limitations on charitable deductions ensure that this will occur.
Aside from the concern with the overall level of revenue is the concern about who does and does not pay taxes.  If there were no limits on charitable deductions, then those people with large assets relative to their taxable income (i.e., the wealthy) would be able to completely avoid income taxes by annually transferring assets to charity.  This is especially concerning given that these transfers might very well go to private family foundations controlled by these wealthy donors.  Those who did not have large assets relative to their income could not avoid taxation in this way.  This could create a system where income taxes would be paid only by those who were not wealthy.
Such an outcome, where only wealthy people paid no income taxes, is potentially offensive.  The income limitations on charitable deductions prevent this outcome.  Regardless of how many assets are transferred to charity, a person cannot deduct more than half of his or her income.  For transfers of less-favored assets or transfers to less-favored charitable entities (such as private family foundations) the share of income that can be deducted is even less.
There is sometimes confusion about the importance of the income limitation rules.  If we are thinking of charitable gifts as gifts from income, rather than gifts of accumulated assets, it is difficult to imagine who would be making such large gifts of income.
We might think that these income limitations would apply only to some rare individuals who desired to spend just a tiny fraction of their income.  If we think of charitable gifts as coming from income, then a person wishing to give away 80% or 90% of income must have taken some extreme vow of poverty!  Since such individuals are rare, and, even when they do exist, are unlikely to be major donor prospects, this can make the income limitation rules seem almost irrelevant.  This inaccurate perception arises from thinking of charitable gifts as coming out of income, rather than from assets.

In reality, the income limitation rules are far from irrelevant.  Their significance is not from low wealth individuals giving away most of their income, but rather from high wealth individuals making substantial transfers of assets.  The issue arises with high net worth individuals, not only because their assets are a very high multiple of their income, but also because charitable planning often involves large one-time transfers, rather than consistent transfers over many years. 

For example, a person may wish to transfer a large block of low basis shares in a family owned corporation into a Charitable Remainder Trust prior to contemplating the sale of the business.  (This transaction can avoid the capital gains taxes that would otherwise have to be paid upon the sale of the business.) Such transactions usually envision a single large transfer of assets in one year.  These large one-time transfers regularly come into conflict with the income limitation rules.
Income limitation rules can become an issue not only for large transactions of the super-wealthy, but also for anyone with high assets relative to income.  This is particularly common among retirees who have accumulated substantial assets, but may have little regular income.  In fact, academic research has demonstrated that a large proportion of people in the United States giving 10% or more of their income to charity were relatively wealthy retirees with high assets and low income.  (See James, R.  N., III, & Jones, K.  S.  (2011).  Tithing and religious charitable giving in AmericaApplied Economics, 43(19), 2441-2450.) In the same way, one might expect a substantial share of donors hitting the income giving limitations to also fall into this category.
The highest amount of income that may be deducted using charitable deductions is a 50%.  This highest limit is reserved for certain types of gifts going to a public charity, government, or operating private foundations.  Because gifts to governments or operating private foundations are rare, the remainder of the chapter will simply refer to gifts to public charities. 

Note that the typical private foundation is a non-operating private foundation.  In other words, it simply holds assets and makes distributions to public charities, but it does not actually run nonprofit ventures such as schools, hospitals, or churches.  In the remainder of this chapter, the term “private foundation” will refer, technically, to this most common type of private foundation, the non-operating private foundation.  This chapter will also refer generically to “income.”  Technically, the definition of income for charitable income limitation purposes is adjusted gross income for the year of the gift excluding any net operating loss carry back.  But, no one wants to read “adjusted gross income for the year of the gift excluding any net operating loss carry back” 300 times, so this chapter will simply use the term “income.”

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