Choosing a Charitable Giving Vehicle

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REV: JUNE 17, 2014
ROBERT C. POZEN
MAYUR DESAI
MAURA A. GRAUL
Choosing a Charitable Giving Vehicle
Introduction
As financial advisor Elaine White glanced at the clock, she sighed upon realizing that it was
already well past 8:00pm. It was mid-December 2013, and many of her clients were making last
minute requests for tax-related advisory services before the new year. Thankfully, though, she only
had two families left to review before heading home. As she quickly reviewed the two files, she noted
that they were trying to solve the same problem: both were hoping to make a charitable contribution
this year but were trying to determine the best charitable vehicle to use. White grabbed another cup
of coffee, rolled up her sleeves, and began to review the financial information on each family.
Anne and William Carson
Anne and William Carson were upper-middle class clients of White’s financial advisory services.
Anne was an engineer making $125,000 annually, and William was a freelance writer who typically
made $60,000 each year. 2013, however, was especially fortuitous for William, and he earned $170,000
in income. The Carsons could claim $50,000 in itemized deductions (before accounting for potential
charitable donations). The Carsons’ income placed them in the 33% tax bracket.
While the Carsons planned to save a large portion of this additional income, they were also
interested in making a charitable contribution. The Carson’s typically donated $1,000–$2,000
annually, primarily to their church and local community organizations. This year, they were open to
making a significantly larger charitable donation of $15,000, but were weighing this option against
investing the extra income and continuing to make their typical annual donations. Furthermore, they
were somewhat conflicted as to which charity they wanted to donate to; therefore, they wanted to
learn more about charitable vehicles which would allow them to receive a tax deduction this year but
delay distribution decisions until a later date.
________________________________________________________________________________________________________________
Senior Lecturer Robert C. Pozen and Mayur Desai and Maura A. Graul (MBAs 2013) prepared this case. This case is not based on a single
individual or company but is a composite based on the author’s general knowledge and experience. Funding for the development of this case
was provided by Harvard Business School. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as
endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 2013, 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1 -800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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Choosing a Charitable Giving Vehicle
Mary and Jack Bradley
Mary and Jack Bradley were longtime clients of White. Jack was a 60-year-old successful CEO of a
mid-sized biotech company in Cambridge, Massachusetts. Mary was a named partner at a prominent
Boston law firm. Through their long careers, the Bradleys amassed a $50 million estate, comprised
primarily of $40 million in securities (stocks and bonds), multiple properties valued at $7.5 million in
total, and an additional $2.5 million in cash. 2013 had been especially fortuitous for the Bradleys, too,
and their expected wages for the year were $10 million.
As of December 2013, the Bradleys had incurred expenses giving rise to $1,200,000 in itemized
deductions, including state and local taxes paid, mortgage interest, and $500,000 in donations to
public charities. With income at this level, the Bradleys were subject to the “Pease” limitations on
itemized deductions, which reduced their deductions by $291,000 to a total of $909,000. The couple
also needed to decide whether to sell restricted stock that Jack received from his company. Due to a
recent run-up in share prices, Jack was keen to sell those shares and lock in gains. His basis in the
shares was $1 million and the current market value was $3 million. The Bradleys’ ordinary tax rate
was 39.6% and their effective long-term capital gains tax rate was 23.8%.
With both Mary and Jack turning 60, the couple began to think about how they wanted to dispose
of their estate. Both had historically been active in various charities and had regularly provided
financial support to causes they believed in, such as their church, their alma maters, and various
foundations. Recently, though, their charitable giving had shifted. Two years ago, the Bradleys’
daughter was diagnosed with breast cancer. Though she was in remission, the Bradleys’ became
interested in making a sizeable donation, roughly $3 million, to a charity focused on cancer research
or patient support. They had come to White to learn more about the options which existed for them.
In the past, they had primarily donated directly to public charities; while the donations had been
universally appreciated, the Bradleys were concerned that a lump sum donation might not be the
best way to ensure that their funds were most impactful. Furthermore, Jack and Mary were not
totally aligned on which cause they would most like to support; Jack’s biotechnology background
made him more interested in research-oriented causes, whereas Mary preferred charities which
focused on improving the lives of cancer patients and their families. Therefore, they were interested
in charitable vehicles which allowed them to delay deciding which charity would be the primarily
recipient of their donation. In addition to seeking flexibility in distribution timing, the Bradleys were
also concerned about the possibility that their daughter’s cancer could return one day. As such, they
were particularly interested in vehicles which could both contribute to a charitable cause and provide
an income stream for their daughter and her family.
Overview of Charitable Giving
In 2011, Americans donated $298.3 billion to charitable organizations, with 65% of American
households donating. The Joint Committee on Taxation estimates that the charitable deduction
caused the federal government to forego $39 billion in tax revenue in 2012. Among those who
donated, the average household donation was $2,213, though the median was significantly smaller at
$870. Higher income individuals were significantly more likely to donate; 98% of high net worth
households gave to charity.1 Charitable tax deductions were used by 80% of taxpayers who itemized
deductions.2
Charitable contributions could reduce a taxpayer’s tax burden in two ways. Charitable
contributions which occur during a person’s life could give rise to itemized deductions. Conversely,
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Choosing a Charitable Giving Vehicle
314-073
charitable contributions at death were deducted from the descendant’s gross estate, thus reducing
any applicable estate taxes. A donation was only tax deductible if it was paid to an institution
qualified by the IRS under § 501(c)(3) of the Internal Revenue Code (IRC). This statute granted tax
exemption to “corporations, and any community chest, fund, or foundation, organized and operated
exclusively for religious, charitable, scientific, testing for public safety, literary, or educational
purposes.” Furthermore, the statute specifically excluded organizations that use net earnings to the
benefit of any private shareholders.3
The value of a charitable contribution was usually based on the fair market value of the donation
at the time of donation. Furthermore, a charitable donation could generally be deducted only to the
extent that it exceeded any sort of economic benefit associated with the donation. For example, when
determining the relevant charitable deduction, bidders in charity auctions subtracted the market
value of the item they won from the price they paid. One exception to the market value rule was the
donation of services; even when a market value could be placed on said service, it was never tax
deductible.
The IRC placed limitations on the amount that a taxpayer could deduct in a given year. A
taxpayer was able to deduct charitable contributions to the extent that those deductions did not
exceed 50% of Adjusted Gross Income (AGI).4 Furthermore, deductions associated with the donation
of capital gain property could not exceed 30% of AGI. Deductions from donations to private
foundations generally faced tougher restrictions; total deductions for such contributions could not
exceed 30% of AGI and deductions associated with the donation of property to a private foundation
could not exceed 20%.
For example, a taxpayer with $500,000 in AGI would have been limited to $250,000 in total
charitable deductions. Of that amount, no more than $150,000 could have been associated with the
donation of appreciated capital gain property to a public charity. Furthermore, no more than $150,000
could have been associated with donations to private foundations, of which no more than $100,000
could have been associated with the donation of appreciated capital gain property to such private
foundations. Any excess could be carried over for up to five years, though it must be applied after
any donations in the current year were deducted. Furthermore, charitable deductions remained
deductible under the Alternative Minimum Tax (AMT).
The IRC often created an especially beneficial scenario when a taxpayer donated appreciated
capital assets directly to a charity. If an individual were to sell an appreciated security and then
donate the resulting cash to a charity, he or she would also be required to pay taxes on any realized
gain on the sale of that asset. Conversely, if the same person were to donate the securities directly to a
charity, capital gains taxes could generally be avoided and a deduction could usually be taken for the
appreciated value of the asset (subject to percentage of AGI limits discussed above).
Charitable Vehicles
After initially reviewing the two files, White began to draft a list of the potential charitable
vehicles available to her two clients. While all vehicles would allow her clients to receive a deduction
in the current year, they varied based on their administrative burden, the timing of the contribution
to the charity, the control they provided to the donor, and the potential revenue stream that the
vehicle delivered.
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Choosing a Charitable Giving Vehicle
Public Charities and Private Foundations
The simplest—and most popular—charitable vehicle was a direct donation to a tax-exempt,
nonprofit organization organized under § 501(c)(3) of the IRC, commonly referred to as “501(c)(3)
organizations.” 501(c)(3) organizations could be divided into two groups: public charities and private
foundations. IRC § 509 delineated the differences between public charities and private foundations by
designating all 501(c)(3) organizations as private foundations unless they meet one of two primary
exemptions. The first exemption included those organizations defined in § 170(b)(1)(A); this statute
highlighted the most common types of public charities, including churches, educational
organizations, and medical institutions. The second exemption focused on sources of funds; if a
501(c)(3) organization normally received more than one-third of its income from public sources, such
as donations, membership fees, or admissions, it could be designated as a public charity. Public
charities were sometimes described as “50% organizations,” referencing the higher deduction
limitations associated with donations to these organizations relative to the 30% limit imposed when
donation to private foundations. There were almost 1 million public charities active in the US in 2013,
representing over half of all 501(c)(3) organizations.
Donations to private foundations enjoyed many of the same tax benefits as donations to public
charities, but the foundations themselves face additional requirements, including:
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4
•
Excise Tax Based on Investment Income: Private foundations were subject to a 2% excise tax
on any investment income exceeding the expense required for the management, conservation,
or maintenance of property held for the production of such income. This tax was lowered to
1% if the distribution percentage of a given year exceeds the 5-year historical average for the
foundation.5?
•
Taxes on Self-Dealing: A private foundation faced additional excise taxes if it participated in
a transaction considered to be an act of self-dealing. Self-dealing included any transaction
between the foundation and a disqualified person (e.g., the primary funding source for the
private foundation). The disqualified person faced an initial tax of 10% of the amount
involved, and a 5% tax could be imposed upon a foundation manager if he knowingly
participated in the transaction. An additional 200% tax could be imposed on the disqualified
person if the act of self-dealing were not corrected in a given correction period.6?
•
Taxes on Failure to Distribute Income: Private foundations were required to distribute a
certain amount of their assets each year, generally 5% of their total assets. If they did not, they
were subject to a 30% tax on the undistributed assets. This tax increased to 100% if the issue
was not rectified within 90 days of IRS notification. A key exception was allowed for major
projects; distributions exceeding the minimum requirement could be carried forward for a
period of five years following the initial distribution.7?
•
Taxes on excess business holdings: Generally, the combined holdings of a private foundation
and its disqualified persons could not exceed 20% of voting stock of a given business. If a
private foundation exceeded this limit, they could become liable for an initial 10% excise tax
on these excess business holdings. After the initial tax had been imposed, the foundation had
to dispose of the excess holdings within a correction period or face an additional 200% tax. 8?
•
Taxes on investments which jeopardize charitable purpose: If a foundation made an
investment which, in any way, jeopardized the carrying out of its exempt purposes, both the
foundation and its manager could each be charged with a 10% tax on the investment. If the?
Choosing a Charitable Giving Vehicle
314-073
investment was not remedied within the taxable period, the foundation faced an additional
25% tax whereas the manager faces an additional 5% tax. 9
Private Foundations could be characterized further depending on whether they acted as charitable
organizations or as grant-making organizations. The majority of Private Foundations were nonoperating foundations, meaning that they primarily supported public charities via grants rather than
actually administering charitable activities. Non-operating foundations that held no endowment and
simply exhausted their annual revenues via grants were described as “pass-through” foundations.
Examples included the Ellison Medical Foundation (funded by Oracle CEO Lawrence Ellison) and
the Chartwell Charitable Foundation (funded by Univision CEO A. Jerrold Perenchio).
By contrast, Private Operating Foundations were relatively less common. Such foundations
devoted most of their resources to organizing and executing charitable activities. The most prominent
example of a Private Operating Foundation was the Bill and Melinda Gates Foundation. While
Private Operating Foundations were still subject to the tax on net investment income, they were
exempt from the excise tax on a failure to distribute income.
From the perspective of a donor, Public Charities and Private Foundations offered different costs
and benefits. From a tax perspective, the IRC provided an advantage for donations to Public
Charities. Donors could deduct donations to Public Charities up to 50% of AGI annually (30% for
capital gain property), while deductions associated with donations to Private Foundations were
capped at 30% of AGI (20% of capital gain property). Furthermore, if a donor contributed to a Public
Charity, he or she could avoid all the administrative costs associated with creating and maintaining a
Private Foundation, which could be quite high relative to the asset size of smaller foundations. (See
Exhibit 1 for average administrative costs of Private Foundations.)
On the other hand, many wealthy individuals chose to create Private Foundations in order to
exert more control over the use of their funds. A Private Foundation allowed an individual to enjoy a
deduction immediately but to distribute funds over time. This could allow the donor to distribute
funds based on performance and impact over time rather than making a single lump payment.
Split Interest Trusts
Split Interest Trusts were another type of charitable vehicle. These types of trusts allowed a donor
to subdivide a given set of assets into claims on income and claims on the principal. One claim could
be given to charity and the other was given to a beneficiary, either the donor or a third party.
Charitable split interest trusts could take on two primary forms depending on which claim is
provided to the charity and which is retained: A Charitable Remainder Trust and a Charitable Lead
Trust.
Charitable Remainder Trusts The most common charitable split interest trust was a Charitable
Remainder Trust. A donor established a Charitable Remainder Trust by first choosing one or more
501(c)(3) organizations to be the recipient of the remainder trust. Though the remainder would not be
distributed to the charity until the expiration of the trust, the recipient organization had to be designated in
the original trust instrument. Furthermore, the trust had to be irrevocable, and no significant changes
could be made to the trust structure after it was created.
The donor first had to choose the term of the Trust. Trusts could either expire after a set number of
years or at the death of the beneficiary. If the donor chose to create a Charitable Remainder Trust
with a fixed term, that term could not exceed 20 years. The donor then had to choose how the trust’s
annual income would be distributed to the trust’s non-charity beneficiary. In a Charitable Remainder
5
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Choosing a Charitable Giving Vehicle
Annuity Trust, distributions to the trust’s beneficiary were a fixed dollar amount—“sum certain”—
each year. Conversely, a Charitable Remainder Unitrust used a fixed percentage of trust assets to
determine the annual distribution. Additionally, a Unitrust could be set up to distribute payments
equal to the lesser of a fixed percentage of assets or the amount of income actually generated by the
trust. This type of trust, called a Net Income Unitrust, prevented the trust from decreasing in value in
years when the fixed percentage exceeds growth. For both remainder trusts and unitrusts, scheduled
annual distributions could not represent less than 5% or more than 50% of the trust’s assets. (See
Exhibit 2 for Charitable Remainder Trust Diagram.)
When creating a Charitable Remainder Trust, the donor had to designate one or more
beneficiaries. A Single-Life trust had just one beneficiary, and the trust expired at that person’s death.
The most common Charitable Remainder Trust typically named the donor as the beneficiary and the
trust expired at the donor’s death. A Charitable Remainder Trust sometimes designated the donor’s
children as its income beneficiaries. A trust with multiple beneficiaries was called a Last-To-Die
Trust, as the trust would continue to be paid out until the final beneficiary had died. However, if
there are multiple beneficiaries, especially if they …
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