New Tax Proposals Alter Charitable Giving Strategies

August 17, 2021

As charitable organizations continue to navigate fundraising strategies during a pandemic, lawmakers consider proposals that, if enacted, would have a significant impact on charitable giving.

Earlier this summer, the Biden administration released the “Green Book,” with its priorities for changes to federal taxes imposed on individuals and businesses that could indirectly impact charitable giving. More recently, legislation introduced in the U.S. Senate proposes to alter the tax deductions for donors who contribute to donor-advised funds and place restrictions on private foundations.

The Ace Act Seeks to Change Donor-Advised Fund Features

U.S. Sens. Angus King (I-Maine) and Chuck Grassley (R-Iowa) recently introduced legislation seeking to modify the charitable deduction rules for contributions to donor-advised funds (DAFs). Under the Accelerating Charitable Efforts (ACE) Act, the timing and amount of a charitable tax deduction for donations made to a DAF would depend on new classifications applied to DAFs. These new classifications are based on the length of time the DAF is established to carry on charitable activities and the type of sponsoring organization that holds the funds.

Policymakers and groups, including the Initiative to Accelerate Charitable Giving, believe the ACE Act is necessary to change the current DAF rules, which allow tax deductions at the time of a charitable contribution even though the money has yet to be used for a charitable purpose. However, the ACE Act proposal has received pushback for the potential negative impact it will have on charitable giving. A group of 285 charitable organizations authored a letter to Congress on Aug. 2, 2021, opposing the ACE Act. They raised concerns that, if the measure is passed, the likely result will be a decrease in charitable giving overall because of the delay in the donor’s ability to claim a tax deduction and the potential limitations on the amount of deductions available. Further, these charitable organizations are concerned with the increased administrative burdens to be placed on charities that administer DAF programs, which could further reduce charitable spending.

New Classifications. First, under the ACE Act, a DAF would be classified as a qualified DAF if the donor’s advisory privileges terminate within 15 years of the date of contribution. If the advisory privileges extend past 15 years, then the DAF would be classified as a nonqualified DAF. As described below, donations to a qualified DAF receive more favorable treatment.

Second, DAFs would be classified based on the sponsoring organization that holds the charitable funds. More favorable treatment would be afforded to a DAF held by a qualified community foundation, which is a tax-exempt charitable organization whose purpose serves the needs of a geographic community no larger than four states and which has at least 25 percent of its total assets in a form other than a DAF. Under the ACE Act, a DAF would be considered a qualified community foundation DAF if either (i) the qualified community foundation limits the donors’ advisory privileges to DAFs with an aggregate value of less than $1 million, or (ii) the DAF is obligated to make qualifying distributions each year of at least 5 percent of the value of the fund. Nonqualified community foundation DAFs are funds that do not satisfy one of these requirements.

Changes to Charitable Deductions. The classifications of DAFs discussed above determine how contributions to such funds are treated under the ACE Act and when they can be claimed. Contributions to nonqualified DAFs and nonqualified community foundation DAFs receive unfavorable treatment in that no income tax deduction is permitted to the donor until such DAF makes a qualifying distribution of the contributions to another charitable organization. In the case of noncash contributions to such DAFs, no deduction is permitted until the property has been sold and the proceeds are distributed to another charitable organization. For any contribution to a nonqualified DAF and nonqualified community foundation DAF, the donor’s charitable deduction is limited to the amount of the DAF’s qualified distribution, which may be lower than the fair market value of the donated property at the time of donation.

Contributions to qualified DAFs and qualified community foundation DAFs would receive only slightly better treatment for noncash contributions, where contributions of non-publicly traded assets would result in a charitable deduction only after the asset is sold. However, unlike contributions to nonqualified DAFs and nonqualified community foundation DAFs, the qualified DAFs and qualified community foundation DAFs need not distribute the proceeds in order for the donor to take the deduction. The amount of the charitable deduction for such a contribution is limited to the amount of the net sale proceeds credited to the DAF.

Example. A donor contributes a parcel of real estate with a value of $200,000 to a DAF in September 2021, and the DAF sells it in late 2023 for net proceeds of $175,000 and distributes only $150,000 to a public charity in early 2024. Under the current rules, the donor would be allowed a charitable deduction of $200,000 on the donor’s 2021 tax return — the year in which the property was contributed based on the fair market value of the real estate at the time of the donation. Under the ACE Act, if the DAF is a qualified DAF or qualified community foundation DAF, the donor would be allowed a charitable deduction on the donor’s 2023 return — the year in which the DAF sold the asset based on the net sale proceeds of $175,000. If the DAF was a nonqualified DAF or nonqualified community foundation DAF, the donor would be allowed a charitable deduction of $150,000 on the donor’s 2024 return — the year in which the DAF made a qualifying distribution of the sale proceeds to a qualifying charitable organization.

Additionally, for any contribution discussed in this section, no charitable deduction is permitted unless the donor provides the IRS with a contemporaneous written acknowledgment from the DAF’s sponsoring organization (the requirements for the acknowledgment vary depending on the type of contribution and type of DAF). The DAF’s sponsoring organization must also independently provide the written acknowledgment to the IRS.

Changes to DAF Distributions. For all DAFs other than qualified community foundation DAFs that fail to distribute contributed property by the applicable tax year (14.5 years after the year of contribution if made to a qualified DAF, otherwise 49.5 years), a tax is imposed on the DAF’s sponsoring organization in the amount of 50 percent of the portion of the contribution that was not distributed.

Changes Impacting Private Foundations. The ACE Act would prohibit any distributions to a DAF by a private foundation from being a qualifying distribution for purposes of the undistributed income excise tax in IRC section 4942. Also, administrative expenses paid to certain disqualified persons would not be considered qualifying distributions for purposes of meeting the minimum distribution requirement. A private foundation would need to report on its annual Form 990-PF any distributions it makes to a DAF.

The ACE Act would remove the 1.39 percent excise tax on a private foundation’s net investment income for each year in which the foundation distributes at least 7 percent of its net assets. The tax would also be eliminated for all limited-duration foundations — those private foundations (1) with a duration specified in their governing documents of 25 years or less and (2) that do not make distributions to a private foundation with any of the same disqualified persons. In the event a limited-duration foundation amends its governing documents or otherwise no longer meets the definition, it would be subject to a recapture tax in the amount of the taxes that otherwise would have been imposed.

Changes to the Public Support Test for Public Charities. The ACE Act would also impact public charities and their public support test calculations by requiring them to treat distributions from a DAF sponsoring organization as received from an individual rather than another charitable organization, unless the sponsoring organization specifies that the amount is not a distribution from a DAF or that no donor had advisory privileges over the distribution. Public charities could attribute the amount to a specific donor if the distribution from the sponsoring organization identifies the particular donor.

Administrative Burdens. By subclassifying DAFs with a focus on geographic areas and length of donor advisory privileges, the ACE Act would create significant administrative burdens on sponsoring organizations. Such burdens could dissuade donors from using DAFs, which serve as an effective alternative to private foundations and result in a multitude of charitable benefits through grant-making and other charitable activities. The ACE Act imposes additional burdens on private foundations and public charities to comply with the additional rules regarding qualifying distributions and public support.

“Green Book”

Earlier this summer, the Biden administration released the “Green Book,” which explains revenue projections and the administration’s proposed areas for tax changes. Many may remember the proposals discussed during the Biden presidential campaign about increased tax rates; the Green Book suggests an individual tax rate increase from 37 percent to 39.6 percent and a corporate tax rate increase from 21 percent to 28 percent. Also, this proposal would increase the long-term capital gains rate from 20 percent to 39.6 percent for those taxpayers with annual incomes exceeding $1 million. Along with the current 3.8 percent tax on net investment income, this change would lead to taxes as high as 43.4 percent on capital gains for certain taxpayers.

The Green Book’s other notable proposal is the removal of the nonrecognition treatment for gifts and bequests of appreciated property. Currently, a transferor of appreciated property by gift or bequest does not realize any gain when transferring the property. This proposal would require the transferor to recognize gain on the appreciation of the property and pay capital gains tax, subject to some exclusions. Each transferor would be allowed a lifetime exclusion of the first $1 million of appreciation, after which the transferor would recognize any appreciation and be responsible for the tax. Additionally, transfers to a spouse or charity would not be a recognition event at the time of transfer and the transferee would assume the transferor’s basis; capital gain would not be recognized until the spouse transfers the property (by gift or bequest), and a charity will never recognize any gain on the transfer of the property.

Effects on Charitable Giving. Increases in the individual and corporate tax rates would likely result in increased charitable giving due to the increased value of a deduction for the taxpayer compared to the current rules. Regarding capital gains, individuals will likely place greater importance on giving to charity and incorporate this strategy into their tax planning; taxpayers will likely prefer to transfer appreciated property to charity rather than pay a large amount of tax upon their death or transfer to a third party. On the opposite side, transferees may seek to transfer received property to charity rather than deal with the risk of paying capital gains tax on the later disposal of the property. This proposal will also increase the importance of estate planning for high-wealth individuals and may result in a greater number of charitable beneficiaries being designated in trusts and testamentary documents.