Limits on individuals' charitable deductions.

EXECUTIVE SUMMARY

* When a donor makes contributions subject to multiple AGI percentage limits, limits and carryovers must be computed and applied in a specific order.

* Taxpayers who consistently make large contributions should consider planned-giving techniques.

* Numerous rules restrict or affect the charitable deduction, including rules on valuation, contribution of services, receipt of benefits and the itemized deduction phaseout.

This two-part article outlines the deduction limits on individuals' charitable contributions and provides basic planning strategies for maximizing the deduction. Part II reviews rules for deductions subject to multiple adjusted gross income percentage limits, planned-giving techniques, valuation requirements, restrictions on donated services and receipt of benefits.

A solid understanding of the limits on charitable deductions helps tax advisers plan strategies for charitable giving. This two-part article discusses the limits, as well as compliance and planning strategies. Part I, in the May 2004 issue, focused on the adjusted gross income (AGI) percentage limits and restrictions, which vary according to the classification of the donee organization and the donated property. Part II, below, reviews the ordering rules for contributions subject to multiple limits; planned-giving techniques for taxpayers who make large contributions; donation valuation requirements; contributions of services; and benefits received.

Hierarchy of Limits

When a donor makes charitable contributions subject to different percentage limits in the same year, calculating the deduction can become confusing, but should be relatively straightforward in most situations. The rules are provided in Sec. 170(b)(1)(B)(ii), (b)(1)(C)(ii), (b)(1)(D)(ii) and (d). First, the donor's total charitable deduction for the current year cannot exceed 50% of AGI. This may place added restrictions on contributions subject to the 30%-of-AGI limit.

Example 1: P's 2004 AGI is $135,000. During the year, he contributes $45,000 to a 50% public charity. He also contributes appreciated securities valued at $30,000 and held for more than a year in another 50% public charity.

P can deduct the entire $45,000 cash contribution, because it does not exceed 50% of his AGI ($135,000 x 50% = $67,500). Although the value of the contributed securities does not exceed 30% of P's AGI ($135,000 x 30% = $40,500), P can only deduct $22,500 in the current year for that donation, because his overall charitable deduction for the current year cannot exceed 50% of his $135,000 AGI. The $45,000 50% contribution limit applies first, which allows only $22,500 of the securities donation currently. The $7,500 unused securities donation is carried forward.

A similar rule is used for calculating the limit on 20% property. A donor's aggregate charitable deduction for 30% property and 20% property cannot exceed 30% of AGI. Deductions for 30% property are taken before deductions for 20% property.

As mentioned above, unused donations are carried forward five years. In carryover years, current contributions are deducted first. This can make it more difficult to use carryovers.

Example 2: C has a $170,000 AGI. In 2004, she makes a $95,000 cash gift to a public charity, which exceeds 50% of her AGI. C also has a $17,000 unused contribution carryforward from 2003.

C can only deduct $85,000 of her current-year charitable contribution, because of the 50%-of-AGI limit. She must now carry forward $17,000 from 2003 and $10,000 from 2004 to 2005, in the hope of using them in that year or later. None of the 2003 carryover is deductible in 2004. From a planning perspective, it is in C's best interest to reduce her charitable giving in 2005 (or a later carryforward year) to use her 2003 and 2004 contribution carryovers. If she cannot deduct the $17,000 by 2008--the fifth carryover year--she will lose it.

The ordering rules for deducting contributions with different limits are provided in Exhibit 1 on p. 368. With so many categories, the calculation of the limits and carryovers can become complex. Besides needing an overall understanding of the rules and an ability to explain them to clients, tax advisers should also invest in tax preparation and planning software, to save nine on calculations.

Exhibit 1: Order for deducting charitable contributions

Contributions subject to 50% limit:
  1. Current-year contributions
  2. Carryovers of contributions made during the preceding five years

Contributions of cash and ordinary income properly to 30% charities:
  3. Current-year contributions
  4. Carryovers of contributions made during the preceding five years

Contributions of 30% capital gain property:
  5. Current-year contributions
  6. Carryovers of contributions made during the preceding five years

Contributions of 20% capital gain property:
  7. Current-year contributions
  8. Carryovers of contributions made during the preceding five years

Large Contributions

What about taxpayers who consistently push the limits with large charitable contributions? Taxpayers who consistently give (or want to give) large donations that exceed their AGI limit should consider planned-giving techniques. In typical planned-giving transactions, the taxpayer contributes funds either directly to a charity, using a charitable gift annuity, or indirectly, using a charitable remainder trust. In these transactions, only a portion of the amount transferred qualifies for a deduction; the rest represents the present value of regular payments that will be made to the taxpayer (or someone designated by the taxpayer) for a term of years, or for his or her life. When properly structured, the charitable organization can end up with a substantial donation.

Example 3: J, age 75, has an annual income of $125,000. In April 2004, he contributes $100,000 to a charitable remainder unitrust. The trust is structured so that J receives a 5% return on the trust assets for the rest of his life. At his death, the charity he designates will receive the remaining trust assets.

At the time of contribution, J receives a $61,192 charitable deduction (based on IRS interest factors for April 2004 (7)). This is slightly less than his 50% AGI limit of $62,500, but uses most of the limit. If the trust earns more than 5% during J's life, the charity, will receive a contribution that exceeds $100,000 at his death.

Planned-giving techniques are the appropriate tool for taxpayers who want to make large charitable donations, but who also need an income stream. These donations can be set up in a wide variety of ways to suit the taxpayer's specific circumstances, and should be explored when the fit is good. (8)

Other Limits

A variety of additional restrictions curtail the deductibility of specific types of charitable contributions.

Contribution of Services

Under Kegs. Sec. 1.170A-1(g), no charitable deduction is allowed for a contribution of services. Unfortunately, donating blood is considered a ser vice and is nondeductible. However, unreimbursed expenses incurred in performing services for a qualified charitable organization are deductible. Sec. 170(i) states that unreimbursed expenses include the (1) taxpayer's out-of-pocket travel and transportation costs, (2) costs of distinctive uniforms that would not be appropriate for dress outside the charitable activity and (3) costs of meals and lodging while traveling away from home. If a car is used, the taxpayer can deduct 14 cents per mile, plus parking fees and tolls. Sec. 170(j) allows charitable deductions for travel expenses incurred by a taxpayer who performs services away from home on a charity's behalf, but only if there is no significant element of personal pleasure, recreation or vacation associated with the travel.

Example 4: M drives some of the children in her daughter's scout troop to a weeklong rally in a neighboring state. While at the rally, M assists in supervising the scouts during meals, activities and at bedtime. M enjoy the rally, but is still allowed a charitable deduction for unreimbursed expenses incurred during the trip. M is eligible for the deduction, because she has a genuine and substantial involvement with the scouts throughout the rally.

If, instead, M's only responsibility was to drive the students to and from the rally, and she spent the rest of her time sightseeing and shopping, her unreimbursed expenses would not be deductible, because only nominal duties would have been related to her performance of services for the scout group.

Benefit-Received Rule

Regs. Sec. 1.170A-1(h) requires a taxpayer to reduce charitable deductions if he or she receives a benefit from a charitable organization in exchange for a contribution. The charitable deduction is limited to the fair market value (FMV) of any property transferred to the charitable organization, reduced by the FMV of goods or services received.

Example 5: L contributes $1,000 to his alma mater's athletic association. In return, the association gives him an athletic jacket with a $125 FMV. L's charitable deduction is limited to $875.

Certain goods and services received in exchange for a charitable contribution may be disregarded, including annual membership benefits offered for $75 per year or less, free or discounted admission to an organization's facilities, free or discounted parking and preferred access to, or discounts on, the purchase of goods and services.

Example 6: M pays $50 to the local natural history museum as an annual membership fee. The membership entitles him to free entry to the museum for an entire year. The normal entry fee is $5 per visit. M's charitable deduction is $50. Under Regs. Sec. 1.170A-13(f)(8)(i), he can ignore the value of the membership benefits he has received.

If a taxpayer makes a charitable donation and, in turn, receives goods with an "insubstantial value," he or she can disregard them. IRS guidelines define "insubstantial value." (9) The guidelines contain three alternative limits adjusted for inflation:

1. The FMV of the benefits received does not exceed the lesser of 2% of the amount contributed, or $82 (for 2004);

2. A charitable donation of at least $41 (for 2004) is made, and the cost of the items received in exchange for the donation does not exceed $8.20 (for 2004); or

3. The taxpayer receives free unordered items having an aggregate cost of not more than $8.20 (for 2004) in connection with a donation request.

Also, under the guidelines, newsletters or program guides (other than commercial-quality publications), are deemed to have no measurable FMV or cost if their primary purpose is to inform members about an organization's activities, and they are not available to nonmembers by paid subscription or through newsstands.

Finally, Sec. 170(l) contains a special provision for charitable contributions to colleges and universities. When an individual makes such a donation and, in return, receives the right to buy tickets for athletic events in the institution's athletic stadium, 80% of the payment is treated as a charitable contribution--20% of the contribution is deemed to be the FMV of the right to purchase the tickets and is nondeductible.

Example 7: B donates $2,500 to the athletic booster organization at a local university. A payment of $2,500 or more entitles a donor to purchase season tickets for seats in the enclosed clubhouse of the football stadium for all home games. B can deduct 80% of his donation, or $2,000; the retraining $500 is nondeductible.

Valuation

For contributions of property (other than cash or regularly traded securities), the property has to be valued at the gift date to determine the donation. Taxpayers are also required to have certain donated property appraised by a qualified appraiser; the requirements are set out in Regs. Sec. 1.170A-13. An appraisal is required for property (other than cash and securities) with a FMV of more than $5,000 and for donations of nonpublicly traded stock with a FMV of more than $10,000.

When an appraisal is required, it is also necessary to attach Form 8283, Noncash Charitable Contributions, to the return. A properly completed Form 8283 includes a signature by a qualified appraiser (Section B, Part II), and a signed acknowledgement by the donee organization that it has received the property (Section B, Part IV).

In addition, for donations of art with a FMV of $20,000 or more, it is necessary to attach a complete copy of the signed appraisal to the return. The appraisal must be made not earlier than 60 days before the date the property is contributed, and before the due date (including extensions) of the return claiming the deduction. Failure to file a properly completed Form 8283, with attachments, will result in disallowance of the deduction, unless the disallowance was due to a good-faith omission.

In Todd, (10) the taxpayer did not file a properly completed Form 8283, and provided no evidence of a qualified appraisal for a nonpublicly traded stock contributed to a private foundation. As a result, the Tax Court held that no deduction was allowable for the stock contribution, despite the IRS's allowance of a deduction for the stock's cost basis.

It is always in a taxpayer's best interest to comply with the Kegs. Sec. 1.170A-13 disclosure and substantiation requirements and to obtain an appraisal from a highly qualified, independent appraiser. The appraiser's reputation is important, because on audit the appraiser's qualifications will be analyzed, as will the quality of the appraisal.

Itemized Deduction Limit

Charitable contributions are itemized deductions subject to phaseout. The phaseout rate is slow as AGI rises, but can have an unexpected and adverse effect on high-income taxpayers. In 2004, a taxpayer with a $500,000 AGI will have his or her itemized deductions reduced by $10,719 (($500,000 - $142,700) x 0.03); a taxpayer with a $1 million AGI will lose $25,719 (($1,000,000 - $142,700) x 0.03). (11) The overall limit on itemized deductions is most likely to surprise high-income taxpayers when charitable contributions are their only significant itemized deduction. Taxpayers in the seven states that do not impose an income tax may fall into this category. (12)

Example 8: In 2004, X has a very successful year and receives an unusually large bonus. The bonus, combined with his other income, gives X an AGI of $1.35 million. X is concerned about his 2004 tax liability and suggests to his tax adviser that he contribute $50,000 to his favorite charity before year-end.

If this is X's only significant itemized deduction, he will lose $36,219 (($1,350,000 - $142,700) x 0.03) as a result of the overall limit--a significant portion of the tax savings from his charitable contribution will be lost, due to the phaseout. If X really wants to make a $50,000 charitable contribution, he should make it in a year in which his income is lower and the phaseout is smaller. Fortunately, the overall limit on itemized deductions is currently scheduled to be reduced each year beginning in 2006, disappearing completely in 2010.

Conclusion

To provide quality tax services, tax advisers need a solid understanding of the numerous restrictions on charitable deductions. Armed with this understanding, they can recognize and alert their clients to situations in which the limits may adversely affect charitable deductions. This article should assist tax advisers in identifying such situations and in calculating such limits.

For more information about this article, contact Dr. Swift at [e-mail].

(7) Assumes birth date of Jan. 1, 1929, annual 5% payout made at the end of each year, 3.8% interest rate, based on 120% of the applicable Federal midterm rate for April 2004; see Rev. Rul. 2004-39, IRB 2004-14.

(8) Planned-giving techniques are typically more advantageous for older taxpayers, because the contribution's deductible portion increases with age.

(9) See Rev. Procs. 92-49, 1992-1 CB 987 and 90-12, 1990-1 CB 471.

(10) John C. Todd, 118 TC 334 (2002); see Swift, "Limits on Individuals' Charitable Deductions (Part I)," 35 The Tax Adviser 296 (May 2004).

(11) Certain itemized deductions are reduced by 3% of AGI over a threshold of $142,700 for 2004. Those deductions subject to the overall limit cannot be reduced by more than 80%; see Sec. 68(a) and Rev. Proc. 2003-85, IRB 2003-49, 1184.

(12) The following states do not impose an income tax on individuals: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

Kent Swift, Ph.D., CPA

Professor

Zayed University

Dubai, United Arab Emirates