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Conrad Teitell Comments on Obama Budget
Taxwise Giving has been a mainstay of the charitable gift planning industry for over 47 years. In this excerpt from the March 2009 edition, editor Conrad Teitell, LL.B., LL.M. offers his take on the 28% bracket brouhaha, tax strategies before and after 2011 effective date if the charitable deduction proposal is enacted, and an opportunity for urging extension and expansion of the IRA charitable rollover.
Charitable deduction proposal — in brief. Starting in 2011, charitable and other itemized deductions for taxpayers in tax brackets over 28% would be taken as if they were in the 28% bracket. (Details below.)
Current law — the charitable and other itemized deductions. High income taxpayers in the top 33% and 35% top brackets deduct their charitable contributions, mortgage interest, state income taxes and other itemized deductions in their top brackets. So a donor in the 35% bracket who makes a $10,000 gift deducts $10,000 (subject to the AGI ceilings and five-year carryover) and saves $3,500 in taxes — making the donor’s out-of-pocket cost $6,500. True, she saves $3,500 in taxes. But had she made no gift, she’d have $6,500. So the charitable deduction isn’t a tax bonanza; it encourages giving by reducing the out-of-pocket cost. Many donors view the tax benefits as a way of giving even more to charity.
Suppose a donor in the 35% bracket wishes to give $1,000 of her net worth to charity. In her 35% bracket, after the $1,000 charitable deduction her net worth is reduced by only $650 ($1,000 gift minus $350 tax savings). She can actually make a gift of $1,538 and that would reduce her net worth by $1,000.
Formula to determine how much a donor can contribute and reducenet worth by $1,000:
X (amount of gift that reduces net worth by $1,000 = $1,000/100% minus top tax bracket
Example. Donor is in the 35% bracket.
X = $1,000/100% minus 35% (.65) = $1,538
Proposed budget FY 2010 — income tax. Let’s do the numbers. The charitable deduction, mortgage interest and other itemized deductions for high-income taxpayers would only be deductible in the 28% bracket. So a donor in the 35% bracket, for example, who contributes $10,000 would save $2,800 (instead of $3,500), making the out-of-pocket cost $7,200 (instead of $6,500).
Immer schlimmer. If the 28% deduction limitation rule (let’s call it the 28% DLR) would be bad for high-income itemizers, it would be worse than advertised. The press reports that I’ve seen say the top brackets are 33% and 35%. That is indeed true for 2009 and 2010. But the 28% DLR would apply starting in 2011. The top income tax rates will then be 36% and 39.6%. That would make the out-ofpocket cost $7,200, not $6,040. And a donor who wanted to make a larger gift by giving away his tax benefits (reduce his net worth by $10,000) under the 28% DLR could contribute $13,888. But if his gift were deductible in his 39.6% tax bracket, he could contribute $16,556. And the $2,668 difference isn’t chopped liver to the donee charity.
Question. If the 28% DLR is enacted, would donors reduce their charitable gifts?
Answer by many umbrella groups of charities. The 28% DLR would decrease charitable gifts; not a good thing in normal times, but especially harmful in these troubled times. Charities are being called upon to provide additional services and their gifts, income and endowments are down.
Proponents of the 28% DLR answer. Giving by the wealthy won’t decrease and if it does, not by much. And the extra tax dollars will be used to provide health care for millions of Americans.
Others say. This would result in a shifting of support away from charities such as colleges, universities and cultural institutions.
Proponents of the 28% DLR say. Limiting the charitable deduction to 28% for taxpayers in higher brackets is fair because taxpayers who are in the 28% bracket can’t deduct their gifts in higher brackets.
Counterpoint. Those in the 33% and 35% brackets — and those who will be in the 36% and 39.6% brackets starting in 2011 — have their income taxed in those brackets. Obviously, 28% bracketeers don’t. So 36 and 39.6 percenters should not be subject (or subjected) to the 28% DLR.
Proponents of the 28% DLR say. The majority of taxpayers (about 2/3) who take the standard deduction get no tax benefit whatsoever from their contributions. So why are wealthy taxpayers complaining about the 28% DLR?
Counterpoint. The standard deduction is a substitute for the charitable, mortgage interest and other deductions. Those deductions are built into the standard deduction. If non-itemizers have itemizable deductions that are greater than the standard deduction, they become itemizers.
Question that I have. Would the 28% DLR be a foot in the door that would lead to the eventual elimination of the charitable and other itemized deductions — the so called flat tax?
Whether income taxes should be increased is open for debate. But the 28% DLR would be a smoke-and-mirrors tax increase. The administration’s budgeteers have estimated what it will cost to run the government, to provide health care benefits and to try to get us out of the economic mess; presumably also taking the deficit and the national debt into account. Their conclusion: The government has to collect more taxes. One way would be to increase the top income tax rate above 39.6% starting in 2011. That would not sit well — especially atop the scheduled increase in the capital gains rate from 15% to 20% starting in 2011. (Some capital gains are already taxed at above 20% — discussed soon.) But suppose the top income tax rate could be raised without having a higher rate appear in the tax table? Voilà! That’s what the 28% DLR would do.
Flash — the top income tax rate is, in effect, currently above the advertised (tax table) top 35% rate. Just as the Shadow (a radio hero of yesteryear) could cloud men’s minds so that they could not see him (he learned that in the Orient), the tax writers years ago increased taxes without higher rates appearing in the tax tables.
Let’s take a look at the Pease Limitation and PEP to see (see through) those long-existing stealth tax increases.
Once upon a time there was an Ohio Congressman Donald Pease. The late and highly respected U.S. representative’s name lives on in tax eponomy as the Pease Limitation. Back in the last century Congress was working on the Omnibus Budget Reconciliation Act of 1990. How could Congress impose a tax increase that wasn’t visible to the layperson’s eye? Piece of cake, must have thought Rep. Pease. Let’s not disturb the peace. Just limit some otherwise allowable itemized deductions (including the charitable deduction) for high-income taxpayers in any given year.
Enter the Pease Limitation. Starting in 1991, some otherwise allowable itemized deductions were reduced by 3% of the amount by which a taxpayer’s adjusted gross income exceeded $100,000 (for married couples filing separate returns, the AGI threshold was $50,000).
Example. A taxpayer’s AGI was $110,000. His otherwise allowable deductions were reduced by $300 ($110,000 less $100,000 threshold times 3%). This provision effectively increased the marginal income tax rate of affected taxpayers by approximately one percentage point. And the Internal Revenue Code’s complexity was also increased. Two for the price of one percent.
Allowable deductions for medical expenses, casualty and theft losses, and investment interest were not subject to the Pease Limitation but charitable deductions, state and local tax deductions and mortgage interest were. Total deductions subject to the limit couldn’t be reduced by more than 80%. For tax years after 1991, the $100,000 AGI threshold was indexed for inflation. This provision was originally scheduled to expire after 1995. However, continued budgetary pressures (surprise!) resulted in the Pease Limitation being made permanent.
By 2009, indexation for inflation has increased the AGI threshold to $166,800 ($83,400 if married, filing separately).
Under EGTRRA ‘01, the Pease Limitation is being repealed piecemeal (Peasemeal?). For 2006 and 2007, the 3% reduction was reduced to 2% and for 2008 and 2009 it is 1%.
The original 3%, then 2% and now 1% reduction — called the Pease haircut by some insiders — is suspended for 2010. But it is scheduled to clip you again starting in 2011 — and at 3%.
Jam satis (enough already) with the puns; let’s move on.
PEP — the personal exemption phaseout. This hidden from-view tax increase has been with us since fin de 20th siècle and is indexed for inflation. For example, in 2009, married taxpayers start to lose the benefit of their personal exemptions when their AGI is $250,200 and lose them entirely when AGI reaches $372,700. This rule is suspended for 2010 but returns starting in 2011.
Enactment of the 28% DLR is not a fait accompli. Powerful members of the House and Senate tax-writing committees in both parties have criticized it. Treasury Secretary Timothy Geithner told Senate Finance Committee Chairman Max Baucus (D-MT) that the administration was open to other options. On the very next day, however, he defended the 28% DLR telling the House Budget Committee that few taxpayers would be affected.
This just in. On March 10, House Ways and Means Chairman Charles Rangel (D-NY) told reporters that he will hold hearings (no date specified) on the administration’s proposal to limit the value of itemized deductions for upper-income taxpayers. He said that he is deeply concerned about the effect that the deduction limitation would have on charitable contributions. He earlier told reporters: “I have a couple of more years left in Congress. I would never want to have an adverse effect on anything that’s charitable or good.”
CHARITABLE TAX PLANNING IF THE DEDUCTIBILITY SKY WILL FALL TO 28% STARTING IN 2011—
For those who can afford it:
• Accelerate to 2009 and 2010 gifts that would otherwise be made in 2011 and beyond (taking AGI ceilings into account).
• If the IRA charitable rollover law expiring this year is extended into 2011 and beyond, required minimum distributions that can be rolled over tax free will be even more advantageous for top-bracket taxpayers. Although there is no charitable deduction, not being taxed on otherwise taxable income is the equivalent of a charitable deduction. So it would be tax-savvy to avoid a 39.6% tax on a $100,000 RMD. Giving $100,000 from non-IRA assets in 2011, assuming it is deductible (AGI ceiling) would save $28,000 in taxes. But not being taxed on a $100,000 IRA rollover gift would save $39,600.
• Create non-grantor charitable lead annuity trusts. Although there is no income tax charitable deduction, an income stream is created for charity and property can be passed on to family members at the end of the trust term at little or no gift tax cost. Currently, there’s a big discount on passing on property to family members through
CLATs — the low value (compared with a year ago) of assets used to fund a CLAT and historically low section 7520 rates that are used to compute the value of the charity’s and family members’ interests.
Suggested action by charities while Congress is considering the 28% DLR:
• Many charities have already told members of Congress their concerns about the 28% DLR. If you too are concerned, add your voice.
• Ask Congress to make permanent the direct IRA charitable rollover law that expires this year. That tax-incentive has been weakened by the suspension of required minimum distributions for 2009.
• Ask Congress to expand the IRA charitable rollover and authorize tax-free IRA rollovers for life-income charitable gifts that would provide retirement income for the donors. This expansion would not cost the Treasury anything and can, in fact, have a positive revenue effect. The charities benefit and its donors can retain retirement income. This would be all-win legislation. The Senate budget resolution for FY 2009 specifically dealt with extending the then expired IRA/charitable rollover law and expanding it: “reinstatement of expired tax relief, such as enhanced charitable giving from individual retirement accounts, including life-income gifts” (emphasis supplied).]
The ability to roll over an IRA for a life-income gift enables charitable individuals to benefit charities in these troubled economic times and retain retirement income.
Under charitable life-income plans, the IRA owner will be taxable on income received at ordinary income tax rates. Because the payouts are 5% or more, there will be more income paid with the charitable plans than under the normal payouts of the required minimum distribution rules. The higher payout amounts will produce greater tax revenue for the Treasury.
The story on capital gains taxation. Staring in 2011 the rate on long-term capital gains that are now taxed at 15% will be 20%. However, gains attributable to unrecaptured depreciation on real estate are now taxable at 25% and will continue to be taxed at that rate in 2011 and thereafter. Capital gains on tangible personal property (e.g., artworks) are now taxed at 28% and in 2011 and later years will continue to be taxable at that rate.
© Conrad Teitell 2009. Volume XLVII, No. 7. Published monthly by Taxwise Giving, 13 Arcadia Road, Old Greenwich, CT 06870. Annual subscription $195. Phone: (800) 243-9122 or (203) 637-4553; fax: (203) 637- 4572; email: email@example.com. Used by permission.