Beware the new holiday Grinch of charitable planning!

Beware the new holiday Grinch of charitable planning!

Delay in depositing donor's end-of-year IRA checkbook gift leads to a 50% penalty
Article posted in Income Tax, Regulations on 27 November 2018| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 5 December 2018
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Summary

Russell James provides some great year end planning tips and illuminates one deadly trap. Donor beware.

 

By: Russell N. James, III, J.D., Ph.D., CFP

As we enter the holiday season, the mind naturally turns to heart-warming stories of end-of-year charitable tax planning.  (Or is this just me?)  Like the Grinch who stole Christmas giving, the Tax Cuts and Jobs Act (TCJA) of 2017 drastically reduced the number of itemizers.  Fewer itemizers means fewer people who can use charitable tax deductions.  Despite the loss of these tax “presents” under the charitable giving “tree,” some clever Whos in Whoville have found other reasons for non-itemizers to celebrate the giving season: bunching, appreciated assets, and Qualified Charitable Distributions (QCDs).

Bunching

The bunching strategy means making several years’ worth of charitable gifts in a target year, typically into a donor advised fund.  In the target year, giving is so much that deductions exceed the standard deduction.  This turns the non-itemizer into a temporary itemizer.  The donor uses these charitable giving deductions in the target year.  In non-target years, the donor makes no charitable gifts and takes the standard deduction.  A donor who contributed to a donor advised fund can make transfers from it to charities during non-target years.  In this way, the donor’s favorite charities continue to receive funds at the same time and amount as before.  But, the deductions are all “bunched” into the target year.

Appreciated Assets

Giving appreciated assets allows donors to benefit from avoiding capital gains taxes, whether they itemize or not.  Suppose Cindy Lou Who is preparing to write a check to her favorite charity for $10,000.  Cindy also owns $10,000 of Apple stock that she bought for $1,000.  If she sells the stock, she will have to pay taxes on $9,000 of capital gain.  The TCJA Grinch has made these taxes even higher because now she can’t deduct her state-level capital gains taxes.  (Like most major donors, she already exceeded the cap on such deductions with her property taxes and state income taxes.)  But, the story has a happy ending.  At the last minute, Cindy’s heroic advisor swoops in and says, “Don’t give that $10,000 to charity! Use it to buy $10,000 of new Apple stock and give the $10,000 of old Apple stock to the charity.”  The charity is happy.  It still gets a $10,000 gift.  (If the charity doesn’t know how to accept stock, Cindy gives to her donor advised fund and directs it to write a check to the charity.)  Cindy is happy.  She made a $10,000 gift of stock.  Her portfolio didn’t change.  But, the TCJA Grinch is thwarted because Cindy has eliminated the capital gain from her portfolio.  (And, incidentally, there is no “wash sale rule” waiting period because Cindy gave gain property, not loss property.)

QCDs

Finally, for those donors age 70½ or older, switching from itemizing to non-itemizing may not matter.  In either case, the most tax efficient way to donate is usually through a QCD from an Individual Retirement Account (IRA).  Those age 70½ or older are forced to take required minimum distributions (RMDs) out of their IRAs.  Distributions out of a traditional IRA count as income.  But, a QCD transfers directly from the IRA to a charity, counts against the RMD, and doesn’t count as income.  The donor can give up to $100,000 per year this way, even if the RMD is much less.  For many reasons, having no income (QCD) is better than having income and a deduction (an IRA distribution and a deductible gift).

But, as we approach the end of the year, a lurking QCD villain threatens to spoil this beautiful solution.  Many large IRA custodians now allow account holders to have an IRA checkbook.  Using the funds in an IRA becomes as simple as writing a check.  Wonderfully, this works for writing checks to charities as well.  The donor uses the IRA checkbook to write a check to charity and, presto, she has made a QCD.  Congratulations!  Except…

Except the donor cannot make a QCD.  Only the custodian of the IRA can make a QCD.[1]  And this difference affects the timing of the QCD.  When the donor writes a check from an IRA checkbook to a charity, has the custodian acted? No.  When the donor hands the check to the charity, has the custodian acted?  No.  The first time the custodian acts is when the custodian transfers the funds to the charity after the check is deposited.  If this doesn’t happen before the end of the year, the QCD is not counted until the next year.

How to Turn Your Donor into the Grinch

Suppose Cindy Lou Who and Betty Lou Who attend their favorite charity’s Christmas event.  Cindy writes a $10,000 check to the charity from her regular checking account.  Betty is over age 70 ½ and has a $10,000 RMD from her IRA.  So, Betty writes a $10,000 check to the charity from her IRA checkbook.  The charity organizers get busy with their New Year’s Eve party planning, and don’t get around to depositing the checks until January 2nd.  Does this cause any problems for Cindy?  No.  Cindy has made a tax deductible gift at the point the check was delivered to the charity.  Does the cause any problems for Betty?  Yes.  Betty has failed to take her $10,000 RMD for the year.  Betty will have to pay a $5,000 penalty to the IRS because the charity delayed in depositing her check.  The $10,000 gift will count as a QCD, but only in the following year.  So, the charity needn’t worry about asking her for a QCD gift next year.  In fact, since the charity’s delay forced Betty to pay a $5,000 IRS penalty, the charity probably needn’t worry about asking her for anything ever again.

The IRA Checkbook QCD Trap

This potential trap is so dangerous, because this isn’t the way it works with any other checks the donor writes to charity.  With normal donations, a completed gift occurs when the donor puts the check in the mail.[2]  The gift is complete because the donor has delivered valuable property (a check with sufficient funds) to the agent of the charity (the U.S. Postal Service). However, for a QCD the gift must qualify under both the normal charitable deduction rules and the QCD rules.[3]  The QCD rules require action by the custodian[4], not just the account holder.

Conversely, if the custodian mails the charity’s check to the donor’s address, the custodian may have acted, but the transfer is not yet a completed gift under normal charitable deduction rules.  The charitable gift is not complete until the donor puts the charity’s check in the mail addressed to the charity.[5]  This timing risk pre-dates the use of IRA checkbooks.   But, this timing issue may be less likely to be discovered, absent an audit, because IRA custodians often report all their distribution checks on form 1099-R based on the timing of their issuance of the check, not the depositing of the check.  Finally, if the IRA custodian mails a check directly to a charity, the gift is complete when the check is in the mail.  But, having the IRA custodian mail directly to the charity is less common because it may require a medallion signature guarantee.

What happens if the donor writes a check to the charity from an IRA checkbook and the charity doesn’t cash the check until the following year?  The 1099-R form will not reflect a QCD for the year.  Assuming other distributions are not sufficient to meet the RMD, the taxpayer will receive a tax penalty of 50% of the unpaid RMD.  Does this mean that a charity should have a team stationed at the ready to madly record and deposit any end-of-year IRA checkbook gifts?  If the charity doesn’t want to turn any of their donors into the Grinch, then, yes actually, it does!


[1] A QCD “is made directly by the trustee to an organization” IRC § 408(d)(8)(B)(i)

[2] Treasury Regulation 1.170A-1(b)

[3] IRC § 408(d)(8)(C)

[4] IRC § 408(d)(8)(B)(i)

[5] Is this a completed QCD at this moment?  Although not specifically addressed by regulations, the custodian has transferred valuable property, the check, from the individual retirement plan which has then been transferred to the agent of the charity.  Thus, this arguably qualifies as a distribution at this point.  The contrary view would be that no distribution has occurred until the moment the money actually leaves the individual retirement account.  In this case, the “trap” would apply to every QCD check, not just the IRA checkbook QCD check.  However, this timing mismatch would not appear on Form 1099-R when IRA custodians report their distribution checks based on the timing of their issuance of the check, and thus this timing mismatch would not be obvious in triggering RMD penalties.

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