If you donate to a charitable organization, or multiple organizations, would you be open to learning a strategy to make money through your charitable gift? Hear me out, because you have probably been making one particular tax mistake forever.
More than 90 percent of donors are stuck in the paradigm of giving cash to charities, which is often the least tax-efficient or wealth-efficient process for funding philanthropic objectives. We all do it. A worthy cause presents itself and, bam!, we whip out the checkbook and start writing. As a nation, we are the leaders of the free world in charitable dollars donated to worthy organizations. We are also a nation which leaves huge tax breaks on the table because we never learned how to optimize or make money on gifts to worthy charities.
Let me prove it to you.
Note: I'll use round numbers to simplify the importance of this strategy — your CPA can easily provide calculations for your planned gift.
Assume you are in California, flirting with a combined federal and state income tax rate of 50 percent, with a taxable income (AGI) of $1 million.
- With an AGI of $1 million, a 50-percent combined tax rate means a $500,000 tax bill.
- Your remaining, spendable income is $500,000.
- You decide to donate $50,000 to a worthy, 501(c)(3) charity
Now let me illustrate your giving model using $50,000 of cash or stock. Chart one below, on the left, shows the deduction you receive when donating $50,000 in cash or stock to charity. Chart two, on the right, demonstrates what happens when you implement a much more effective strategy and donate $50,000 of highly appreciated stock.
The chart on the left shows that equal gifts, whether in cash or stock, appear to be pretty much the same. Look closer, however, and you'll see we're dealing with a very different situation. Chart two offers a closer look at what's really going on: Same gift amount to charity, same gift deduction, but that glowing little golden bar represents a $15,000 profit. How is this possible? Here's my secret: The long-term capital gains on the highly appreciated stock had a basis of $10,000, but is worth $50,000, the same tax-deductible value as cash deposited on IRS Form 1040, Schedule A, line 14.
Let's take a look at why and how this works.
The Cash Gift
When you give $50,000 to a tax-deductible charity, you get a tax deduction which reduces your tax bill by $25,000. You have essentially spent $50,000 to buy $25,000 in tax savings.
The Under-Performing Stock
Let's consider a different approach. Let's say you bought $10,000 of promising stock 10 years ago. Initially, the stock did well, climbing to $50,000 in value within a few years. After that, however, it flat-lined. Year after year, it has remained at $50,000 in value. Now here you are, a decade later, sitting on an under-performing stock. You have two obvious options: sell it or sit on it.
If you sell, you make a little bit of profit compared to what you paid, but then you get the capital gains tax bill. This bill is enough to cause many investors to choose option #2 and sit on it.
If you sit on it, you'll avoid capital gains tax but you're still facing a lost opportunity cost, because money that could be invested elsewhere is just sitting there, tied up in this under-performing stock. If you could just move it somewhere without incurring a tax bill, you could do something far more valuable with it.
You do have a third, not-so-obvious option.
Consider a charity you plan to support. Chances are, like most Americans, you plan to write a check. What if you donated that under-performing stock instead? The charity still receives $50,000, it's just in the form of stock instead of cash. You don't pay capital gains on that stock; in fact, you claim the gift on your taxes and Uncle Sam gives you a $50,000 tax deduction on the gift. Remember, ten years ago the stock cost you $10,000; now you'll receive a $25,000 tax savings for your charitable gift. You just made $15,000 off the IRS in the form of a tax refund.
Giving $50,000 in cash to a charity or giving $50,000 in stock to the same charity both give you a $25,000 tax savings on your taxes. But the cash gift cost you $50,000 while the stock only cost you $10,000. In this scenario, the charity receives $50,000, your portfolio is now free of a poorly performing stock and you can take that $50,000 check you had planned to donate and, instead, give it to your financial advisor to sink into a strong investment. That's a win for the charity, your portfolio, your financial advisor, you and the future philanthropic organizations you'll support with the money you make off your stronger portfolio.
Why Do We Give Cash?
When I was five years old, I went to Sunday school and when they passed around the little white envelopes, I dropped in a nickle. Like many Americans, this was my training ground for how to support charitable organizations. Unless we have a really good reason to make a paradigm shift, this is how we fund philanthropy for the rest of our lives. So, let's shift the paradigm.
Consider this: Only $0.27 of every dollar you pay in taxes actually goes to supporting the country's military, welfare, social security, etc. The majority of every dollar ($0.73!) the IRS receives is siphoned off by bureaucracy and fraud. Contrast this with every dollar you give to a private nonprofit. On average, $0.80 to $0.90 of every dollar you give to a 501(c)(3) goes directly to advancing their mission. Only $0.20 or less of a charitable dollar goes to maintaining the organization itself. Nonprofits are far more efficient than the U.S. Government when it comes to serving people in need.
With these numbers in mind, who would you rather give your money to?
Leverage Major Life Events to Fund Philanthropy
The reality of this strategy really comes to light when the time comes for a major life event, like selling your business. Let's say you sell your business for $25 million. You could be looking at an $8 million tax bill. Would you be open to using a charitable planning strategy to make money off the IRS and support a cause you care about when you sell your business?
"Charity" is not synonymous with cash, losing money or a 50 percent tax benefit. It can also mean turning one charitable dollar into a two or three charitable-dollar benefit if we change the way we think about investing in philanthropic work. In making money off the IRS, we are able to give more money away to organizations that are able to do more with it.
This strategy isn't for everyone or every situation. It depends on what's important to you, what your goals are and your individual situation. And while this strategy works with any kind of asset — stock, real estate, etc. — not every asset is conducive to this strategy. So talk with your tax professional to decide what's best for you.
Charitable Tax Profit Harvesting
If you are using this tax-smart strategy, you are in essence making money off the IRS and improving the performance of your non-qualified portfolio.
Here is the breakdown of my strategy for the best tax-smart results:
- Decide on the amount you plan to donate from your cash account (i.e., $50,000)
- Consult with your tax professional to address the efficiency and limitations for those who are making sizable current gifts, not to forget many deduction limits changed to the positive
- Meet with your financial advisor and hand them your check for $50,000 to buy new stock with a new basis
- Direct your advisor to cull out $50,000 of highly appreciated but under-performing stock to give to the charity, stocks which appear to be over-weighted or have little upside future performance
- Have your financial advisor contact the charity to generate the stock transfer direct to their brokerage account
- Provide the gift transfer data to your CPA, who now thinks you are brilliant
- Share what you did with your tax attorney and be advised, he or she may ask you to teach a class to their clients
Talk to your most trusted advisors and discuss whether this tax-smart strategy could optimize your gift.
About the Author
Edward W. Cotney helps families pay less tax and enjoy more life, guaranteed. Ed graduated from the prestigious Professional Mentoring Program in Franklin, IN where he became a family wealth counselor in 2000. He received his certification as a philanthropic developer from the National Philanthropic Training Institute in 2001 and his certification as a business exit planner (CExP™) from the Business Enterprise Institute in 2019. Working as a strategy and tax designer at three law firms over the past 20 years, he applied this practical knowledge to help families and business owners implement planning strategies to reduce income tax or eliminate capital gains taxes upon the sale of a business or appreciated assets.
Lauded for making the complex simple to understand, Ed is well known for providing continuing education classes to professional advisors from basic to sophisticated tax and estate planning techniques, qualified plan conversions, asset protection strategies, exit planning, capital gains elimination, research and development tax credits, domestic asset protection trusts, domestic international sales corporations and business succession or exit planning.
In 2018, Ed published Tax Secrets Made Simple, a book to help families of all income levels pay less tax. Recognized as a thought leader in the field of taxation, Ed initiated the development of an IRA conversion software program using a charitable trust to help professional advisors begin the difficult and complex discussion of converting qualified dollars with a high degree of tax efficiency, a first for the IRA conversion software workspace.
To learn more about Ed's $5 billion gift initiative and how he plans to change giving in America, check out his website at taxsmartIRA.com. You can reach him at (530) 913-0562.
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