Integrating Charitable Giving into Your Estate Planning

Charitable giving is a noble way to ensure your legacy lives on, impacting future generations and supporting causes close to your heart. When structuring your estate plan, there are several philanthropic vehicles to consider, each offering unique benefits and considerations. From bequests to sophisticated trusts and donor-advised funds, understanding these options can help tailor your charitable contributions to align with both your financial and altruistic goals. Here's how you can effectively incorporate charitable giving into your estate planning.

Key Charitable Vehicles in Estate Planning

1. Bequests: One of the simplest ways to make a charitable gift is through a bequest contained within your living trust. This method allows you to specify an amount of money, a percentage of your estate, or specific assets to be given to charity. Bequests are highly flexible, easy to arrange, and can significantly reduce the estate tax burden on your heirs.

2. Charitable Trusts: These are more complex instruments that provide valuable tax breaks and can be tailored to suit different goals:

• Charitable Remainder Trusts (CRTs) allow you to receive an income stream or allow your designated beneficiaries to receive an income stream for a period, after which the remaining assets go to your chosen charity.

• Charitable Lead Trusts (CLTs) provide an income stream to the charity for a set term, and thereafter, the remaining assets revert to you or pass to your heirs, potentially reducing or eliminating gift and estate taxes.

3. Donor-Advised Funds (DAFs): DAFs act as a charitable investment account. You contribute assets which immediately qualify for a tax deduction, and then recommend grants to charities over time. This vehicle is particularly useful for those who wish to remain actively involved in philanthropy without managing a private foundation.

4. Private Foundations: For those with substantial assets, starting a private foundation can be an effective but complex way to control charitable giving. Foundations can fund various charities, offer family members roles in its administration, and create a lasting institutional legacy. However, they require significant management and adhere to strict regulations.

5. Endowments: Setting up an endowment can provide a charity with a permanent source of income, as the principal is kept intact while investment income is used for charitable purposes. This option is appealing if you want to ensure long-term financial support for a charity.

Strategic Considerations for Charitable Giving

Tax Implications: Each vehicle has specific tax benefits and implications. For example, bequests can reduce the size of your taxable estate, while contributions to CRTs and CLTs may reduce both income and gift taxes. Understanding these nuances is crucial in maximizing the tax efficiency of your charitable efforts.

Timing of Impact: Some options, like direct bequests or contributions to DAFs, can provide immediate benefits to charities. Others, such as endowments or CLTs, are structured to give over a long period. Consider when you want your chosen charity to benefit from your gift.

Control and Legacy: Decide how much ongoing control or involvement you wish to have. DAFs and private foundations allow for continued involvement in donation decisions, whereas bequests and endowments are generally one-time arrangements.

Family Involvement: If involving family in philanthropy is important, consider vehicles that support this goal. DAFs and private foundations can engage multiple generations in charitable activities.

Charitable giving within estate planning is not just a way to reduce taxes—it's a strategy to make a meaningful difference in the world while honoring your values. Whether it’s supporting a local community, contributing to global causes, or advancing scientific research, the right charitable vehicles can integrate your philanthropic objectives seamlessly into your overall estate plan. As always, consulting with legal and financial professionals can provide guidance tailored to your personal circumstances, ensuring your charitable contributions are both impactful and aligned with your estate planning goals.

Explainer: Capital Gains Tax

The capital gains tax is a subset of our income tax system. It is imposed by both the federal government (IRS) and the state of California (Franchise Tax Board). The recipient of the income is the one on the hook for paying it.

You’re probably most familiar with paying income tax on your earnings through work. Since our wages are fairly predictable year over year, most wage earners have their employers take out (or “withhold”) their income taxes from each paycheck ahead of time. Then, every April, with a timely filed tax return, each wage earner claims a refund for any excess due back to the wage earner. But our wages are only one form of income we may receive in any given year.

Other forms of income may come in the way of rents from an income property we own and lease to a tenant. Or maybe we receive dividends paid to us because we hold shares in a company that generated profits for the year. Or maybe we own an interest in an oil well and are entitled to royalties from that interest.

Or, more commonly, we sold something for more money than we purchased it for. Profit from a sale is considered income, and it is called a “gain”. (Similarly, if we lost money on a sale, we would call it a “loss”). If something is valued more than what it was purchased for, but hasn’t been sold, it’s considered a “potential” or “built in” gain. It becomes an “actual” or “recognized” gain once you actually sell the asset. A capital gain is a gain on the sale of a capital asset. A capital asset can be a house, vehicle, office equipment, art, construction equipment, stocks, bonds, a trademark, etc. Capital assets are essentially anything you own that is not cash or a retirement account.

Let’s use an example. (The following example is going to be significantly simplified not to include tax deductions or financing instruments like mortgages. We’re also not discussing short-term capital gains in this example).

You purchase a home for $500,000 in cash. That purchase price is considered your “cost basis”, or the starting point for calculating gains and losses. Five years later, your home is worth $750,000. Your cost basis remains the purchase price at $500,000, but you now have a potential gain of $250,000 built into your property. At this point no taxes are due or owed. You don’t actually have the $250,000 sitting in your bank account. You have the fleeting possibility of making that $250,000 if you sell the house today. If your home value dips to $450,000 tomorrow, you would then have a potential loss of $50,000. Your home value is a fluctuating number from year to year, and your potential losses and gains flow accordingly.

Let’s say you decide to sell it to a willing buyer at that $750,000 price. At this point you took an asset that you purchased for $500,000, and you converted it into $750,000. That means you resulted in a recognized capital gain of $250,000. You now have income that actually went into your bank account. You will be taxed by both the federal government and the state of California on that income as a capital gains tax.

Now’s a great time to remind you that this is not a CPA’s post. This is about estate planning, right? Why are capital gains significant in an estate planning context?

Capital gains, as explained above, are taxed when someone makes a profit selling an asset. If you don’t ever sell the asset, there is no taxable event. So what happens if you have an asset with a built in capital gain, and give it away or gift it during your life?

When you make a lifetime gift of an asset, and it has potential gains built into it, you are also giving the recipient a future capital gains tax problem. Let’s use the same example from above, with the house that is worth $750,000, and was purchased for $500,000. If you gave that house to your children instead of selling it, your children also receive the built in capital gains. So if/when your children sell the home, and it’s sold for more than $500,000, then they owe any capital gains tax. Since you never sold the house, someone has to pay the tax, and it’s going to be the owner that sells it.

What if you give the house after you die?

There is a federal tax law that says any gift of a capital asset after death receives what is called a step up in basis to fair market value upon date of death. In plainspeak that means that an asset gifted at death gets all of the built in capital gains eliminated. That’s not a typo. If instead of giving the $750,000 house to your children during life you gave it to them as an inheritance, then they receive the home as if they purchased the home for $750,000! If/when they sell the home, their capital gains exposure is measured from the $750,000 amount and not the original purchase price of $500,000. This significantly reduces or eliminates anyone ever paying capital gains tax on the sale of this home. It’s quite the benefit! You do not need to do anything to receive this benefit. It’s a tax feature available whenever someone dies owning capital assets.

To apply this knowledge to a real world situation, think of a time when a parent added a child to title of their home. The parent’s idea might be to shortcut the transfer of the home by adding the child to title during life, and upon the parent’s death the child receives the home… which is partially correct. They will receive the home. But they will also receive a portion of the parent’s built in capital gains. You see, when the parent dies, only the portion of the capital gains associated with the home that the parent owns gets eliminated. The portion that the child owns stays in place until the child dies or sells the property. In situations with joint title, part of the interest gets the step up at death, but the portion in the hands of the person still living remains untouched. So in most cases, we prefer to transfer appreciated assets after death and not during life.

You can see how knowing the nuances of “everyday” taxes can help when planning ahead. And you can also probably see how once you’ve made certain transfers, you cannot “unring the bell”. We strongly recommend speaking to a professional prior to making large or substantial transfers, even when it involves something mundane like adding a child onto title. Even non wealthy, “straightforward” estate plans can benefit from speaking to an estate planning professional to create a robust and comprehensive plan.