Any possible tax changes for ultra-high-net-worth and high-net-worth investors could result in an increased tax burden. That means there’s motivation to find ways to protect that wealth.
Some solutions that reduce exposure to specific anticipated Biden tax increases involve making charitable donations — a plus for the charitably inclined. Among these vehicles are charitable remainder trusts and donor-advised funds.
CRTs are complicated arrangements that require attorneys to set up and accountants to maintain. DAFs, much simpler and far less expensive, have grown significantly in popularity in recent years.
Both vehicles enable income tax deductions — in the current year or carried forward for five years — on cash contributions of up to 60% of the donor’s adjusted gross income and up to 30% of AGI on contributed assets. These contributions also can reduce the size of taxable estates.
These similarities aside, the two vehicles are quite different.
These features hold new allure for many wealthy families as they wait to see if Congress approves Biden’s ambitious tax agenda for the upper brackets. It’s also possible changes will substantially lower the gift and estate tax exemption from the current $11.7 million.
As for CRTs, they funnel asset income into a tax-advantaged cash stream that goes to the donor or another designated non-charitable beneficiary. This income stream flows for a set term, or often, for the lifetime of the non-charitable beneficiary.
Rules require that these trusts be designed so that, at the end of this period, at least 10% of their funds remain for donation to a charity designated at the outset.
No tax is due on proceeds from the sale of trust assets until this cash goes to the non-charitable beneficiary, potentially years later. When assets are held by individuals, their sale generates capital gains tax in the year that they’re sold.
This difference creates a huge advantage for CRT donors, because they can fund these trusts with highly appreciated assets and then manage them for optimal returns while minimizing tax exposure by adjusting the income stream to spread the tax burden over many years. This advantage would be heightened if, as expected, the current Congress raises capital gains tax rates for high earners.
DAFs don’t allow dispersals to non-charitable beneficiaries. All contributions, including gains from contributed assets, must ultimately be donated to charity. But for many donors, DAFs nonetheless hold distinct advantages, including:
- Ease of creation. Most large financial services companies offer DAF accounts for individual clients. Getting them set up is relatively simple, compared with the extensive legal work needed to create CRTs.
- Substantially lower costs. Creating a CRT can cost several thousand dollars in legal fees and, atop this, recurring fees from accountants for handling required IRS filings and from financial advisors for managing the trust assets. By contrast, charges from financial institutions for DAFs typically run between 0.1% to 1% annually, depending on size, plus a small custodial charge for holding the account.
- Great deal of flexibility. Individuals or families can create and fund a DAF and get the deduction on it that same year. Then they can wait for years to designate charitable beneficiaries and direct specific donations. With CRTs, donors have the pressure of having to name charities upon creating the trust. Such elections are complicated to change down the road, as these are irrevocable trusts, while DAFs enable ongoing review of giving goals and enable regular family meetings about the merits of candidate charities.
- Low barrier to entry. Generally, a DAF can be initially funded with as little as $5,000. With a CRT, that amount in some cases might cover only half of the legal fees to create it, let alone fund it.
- Wide latitude in the types of assets that can be contributed. DAF contributions can include shares of privately held businesses, collectibles such as fine art or even cryptocurrency — as long as valuation methods meet IRS rules. This gives donors more opportunities to get tax deductions without having to pony up cash, as they can donate a wide range of assets they may own.
- Help with itemizing tax deductions. For less wealthy donors, a DAF is a way to qualify for itemizing tax deductions some years, rather than taking the standard deduction. As DAF donations are deductible the year that they’re made, this enables filers to consolidate what, for them, might normally be two years’ worth of charitable donations —potentially, to be made years later — into a single year for tax purposes. This way, they can meet the IRS threshold, set down in the 2017 tax law, to qualify for itemizing deductions. This feature, along with their simplicity and low cost, has led to rapidly increasing use of DAFs. Contributions to them in 2019 ($38.8 billion) increased 80% over 2015.
Meanwhile, as the popularity of DAFs has grown, they’ve drawn criticism as a way to get a huge charitable tax deduction now without actually benefitting a charitable cause for many years.
Yet actual grants from DAFs to qualified charities in 2019, totaling more than $25 billion, represented a 93% increase from 2015. Moreover, proponents say, gaps between funding DAFs and directing donations from them gives donors time to assess the merits of candidate charities. With CRTs, this delay may last an adult lifetime. Yet, as their lack of accessibility makes them somewhat esoteric, CRTs tend to fly beneath the critical radar.
Which of the two devices works best depends on an individual’s situation — how much wealth needs protection, whether an income stream is desired and what charitable goals are involved.
— By David Robinson, CEO and founder of RTS Private Wealth Management