The 2017 Tax Act doubled the estate tax exemption and basically eliminated the tax benefits for charitable bequests for most donors. But creative planning can both help charities and preserve tax deductions for many. It’s time to rethink your plans—and have a talk with your heirs.
The estate tax exemption was increased to $10 million, which inflation adjusted is $11.18 million in 2018 and $11.4 million in 2019 for an individual. For a married couple, the exemption amounts are $22.36 million in 2018 and $22.8 million in 2019. With that large amount of wealth that can be gifted or bequeathed tax-free very few decedents will obtain any benefit from charitable bequests. There were only an estimated 1,890 taxable estates in 2018, according to the Tax Policy Center.
Consider the impact of that on deductions for bequests.
The doubling of the estate tax exemption to more than $11 million is estimated to lower charitable giving by $4 billion per year, according to the National Council of Nonprofits.
The virtual elimination of estate tax for most taxpayers eliminates the incentive for bequests to a charity that has been an integral part of the charitable giving landscape for many decades. How will this dynamic affect charitable giving? It has always been easier for many donors to incorporate a bequest into a will rather than write a large check. Whether that bequest resulted in a tax benefit or not may have been secondary to the ‘culture’ of bequests. Might the doubled estate tax exemption finally change that perception and culture? How should charities change their solicitations considering this? Certainly, emphasizing the nontax benefits of donations, encouraging larger donations to create their own tailored donor agreements, and other techniques might be more common to encourage future bequests.
Creative tax planning, and emphasizing non-tax benefits, may help offset some of these losses. Charitable giving might be modified to provide tax benefits in the new environment. Here are some strategies to consider.
Prepay bequests and get an income tax deduction
Prepaying charitable bequests as “advancement” before death will be beneficial for many making bequests. An advancement is when the bequest is prepaid during lifetime and satisfies the bequest in the will so that it is not duplicated after death. Many donors who have made bequests might never realize an estate tax benefit but because of the size of the bequest could easily realize an income tax benefit if that bequest were prepaid.
Example: Taxpayer has a $100,000 bequest in her will to the American Cancer Society. Although her estate is more than $5 million, she is unlikely to incur an estate tax even if she dies in 2026 or later when the exemption is scheduled to be reduced by half. So, it is doubtful any estate tax benefit will be realized by her estate paying that bequest. If instead that bequest is paid while she is alive it will easily exceed the standard deduction for a single person and provide an income tax benefit.
Charities should educate donors, especially those for whom they have records of having pledged bequests, to consider prepayment for this purpose.
Taxpayer donors should revise their durable powers of attorney for financial matters (and revocable trusts if they have used these in their planning) to permit their agents (successor trustees) to prepay bequests to charities under their wills. They should also make sure that these legal documents permit contributions generally (many forms do not permit them), and to specifically permitting the advancement of charitable bequests. In many cases, the amount of the prepayment will be large enough to surpass the standard deduction increase for income taxes so that an income tax benefit will be realized.
Have heirs make charitable gifts instead of you
Another approach if you totally trust your heirs is to permit them to inherit your estate and then make bequests you would have wanted. The idea behind this type of planning is the heirs may realize a charitable contribution benefit for income tax purposes, perhaps a bigger tax benefit then the parent/benefactor might have realized had the advancement approach above been used instead. In this planning scenario, nothing is included in the will concerning charities. The parent/benefactor might write a non-binding letter of instruction to the heir requesting that they make the donation. “Dear nephew: I wanted to donate $100,000 to the American Brain Foundation to fund research into multiple sclerosis. However, because of the size of my estate relative to the exemption, my estate would not receive a charitable contribution deduction. Therefore, I have made the bequest under my will to you without diminution by this donation, and request that you make it in my stead so that you will at least realize an income tax charitable contribution deduction.”
You could tailor the above approach to be more creative. You might provide in your will: “If I die after 2025 then I hereby give, devise and bequeath $100,000 to the American Brain Foundation to fund research into multiple sclerosis. If I die before 2026 then this bequest shall not be made.” The purpose of this refinement is that if your estate would qualify for an estate tax benefit after 2025 when the exemption is cut by half you may as well make the donation from your estate. If you die before and there will not be an estate tax, well then you defer to your heir to make the donation as discussed above.
The challenge with the above approach is what if Congress changes the estate tax laws before 2026? You could further tailor the provision to address that risk, and so on.
While this approach can work from a tax perspective, the non-tax drawback or risk is obvious. What if the heir prefers a new red sports car over the donation?
Pay charitable bequests out of the income of your estate
Another approach to the no-estate-tax-benefit might be to have a donation directed to be paid out of the income earned by the estate. If the estate pays a donation out of income the estate, even if not taxable for estate tax purposes, this might garner an income tax benefit on the estate’s income tax return. That is potentially another way to secure a deduction.
While this approach is viable from an estate income tax perspective it does become more complex. For example, if you wanted to donate $50,000 to the Michael J. Fox Foundation for Parkinson’s Research, but the income earned by your estate is only $42,000, what should happen to the shortfall? You might make the charitable commitment in terms of or limited to whatever income is earned by the estate and write a separate side letter to your heirs to pay any shortfall. That way, you secure an income tax deduction, assure that much of your intended bequest is made, but have more assurance that just leaving it up to heirs.
Charitable lead trusts can mitigate planning issues created by the new law
There may be an advantage to incorporating charitable lead trusts into some wills to address the contingency of a reduction by a future administration? What about the reduction in the estate tax exemption by half in 2026? Consider the following:
Example: Taxpayer is single and presently has a net worth of $8 million. She has two nephews named as her heirs. She provides in her revocable trust that on her demise a bequest will be made to dynastic trusts, half for each nephew, up to but not in excess of the estate tax exemption. At the present level of $11.8 million, the entirety of her estate will be divided $4 million in trust for each nephew. However, if she dies in 2026 or later after the exemption is halved, or if a future administration in Washington lowers the estate tax exemption amount, diving the entirety of her estate between only her two nephews would trigger a significant estate tax cost. So instead, her revocable trust limits the bequest to each trust to one-half of her remaining estate tax exemption. The revocable trust provides that the excess over that amount passes to a charitable lead trust (“CLT”).
If she dies before the new higher exemption sunsets (or a future administration changes the estate tax) the estate will pass transfer tax-free into GST exempt dynastic trusts for each child.
If the estate tax exemption is reduced to the $5 million pre-Act level as scheduled in 2026 (or by a different administration before that date) the $5 million inflation adjusted exemption amount will pass transfer tax free into the GST exempt dynastic trusts for each child, and the remainder of the estate could pass into a CLT that reduces or eliminates any estate tax, and then after the end of the charitable lead trust term, which will be set to eliminate any estate tax, the excess assets remaining in the CLT will pass to her nephews equally.