Limits on Individuals Charitable Deductions (Part I)

This two-part article outlines the deduction limits on individuals charitable contributions and provides basic planning strategies for maximizing the deduction. Part I focuses on the adjusted gross income percentage limits and other restrictions, which vary according to the classification of the donee organization and the donated property.

Kent Swift, Ph.D., CPA
Professor
Zayed University
Dubai, United Arab Emirates

For more information about this article, contact Dr. Swift at Kenton.swift@zu.ac.ae.

Executive Summary

• Cash contributions to exempt public charities and private operating foundations are generally limited to 50% of AGI; contributions of capital assets are limited to 30% of AGI. 

• More stringent restrictions apply to contributions to private nonoperating foundations, including deduction reductions for long-term capital gain property and lower AGI percentages. 

• In many cases, careful planning of cash and property contributions can maximize deductions subject to AGI percentage restrictions.

In Todd,¹ the Tax Court denied a taxpayers charitable deduction for the fair market value (FMV) of securities he contributed to a private foundation. Because the taxpayer had failed to satisfy two separate Sec. 170 requirements, his $553,847 deduction was disallowed; a deduction was not even allowable for the contributed stocks cost basis. This case illustrates the significant effect that these restrictions can have on an individuals deduction and taxable income.

This two-part article describes the limits on an individuals charitable deductions and provides examples and basic planning strategies. Part I, below, focuses primarily on the adjusted gross income (AGI) percentage limits, which vary based on the classification of the donee organization and the type and character of the donated property. Part II, in the June 2004 issue, will summarize other rules, including planned-giving techniques, contributions of donated services, quid pro quo contributions and ordering rules for individuals with contributions subject to multiple limits. The articles should assist tax advisers in making sense of the charitable deduction limits and provide a framework for analyzing restrictions in specific situations.

To be eligible to receive deductible gifts, a recipient organization must be described in Sec. 170(c); see Exhibit 1. Some of these organizations are categorized as 30% organizations and others as 50% organizations. Under Sec. 170(b)(1)(A), an individuals total deduction for cash contributions to 50% organizations is limited to 50% of the donors AGI. Likewise, 30% organizations are entities for which the deduction of cash donations is limited to 30% of AGI under Sec. 170(b)(1)(B).²

The most widely recognized charitable organizations are Sec. 501(c)(3) charitable organizations;³ see Exhibit 1. However, other exempt organizations qualify to receive deductible charitable donations, including Federal, state and local government entities, which are all 50% organizations. The only restriction in Sec. 170(c)(1) on contributions to governmental entities is that they must be made exclusively for public purposes.

Example 1: E gives $50,000 to the parks department of the county where she lives for development of park space. Because the department is a 50% organization, her contribution deduction is limited to 50% of her AGI in the gift year. E can carry forward unused contributions up to five years.

Thirty-percent organizations include war veterans groups (generally, Sec. 501(c)(19) organizations) and nonprofit cemetery companies owned and operated exclusively for their members benefit (generally, Sec. 502(c)(13) organizations). Individual contributions to fraternal lodges (generally, Sec. 501(c)(8) or (c)(10) organizations) may also qualify for a 30% charitable deduction. To be deductible, the gift must be used exclusively for religious, charitable, scientific or educational purposes, or for the prevention of cruelty to children or animals.

Example 2: J belongs to the local chapter of the Loyal Order of the Moose. He donates $5,000 to the organizations college scholarship fund. The scholarships are awarded annually to outstanding local high school students who have been accepted into a college or university. Such contributions are limited to 30% of Js AGI by Sec. 170(b)(1)(B).

Sec. 501(c)(3) separates charitable organizations into two broad categoriespublic charities and private foundations. The primary difference is that public charities receive their support from a wide variety of individuals and organizations. Such organizations include national public charities (e.g., the American Cancer Society, Easter Seal Foundation and The Nature Conservancy), and local charities (e.g., churches, museums, hospitals and schools). Private foundations (such as the Ford Foundation, Turner Foundation and the Bill and Melinda Gates Foundation) typically receive most of their support from a few sources. The distinction is important, because the deductions allowed for donations to certain private foundations are more limited than those for other Sec. 501(c)(3) organizations. In addition, private foundations can be subject to a variety of penalty taxes.

Public charities are 50% organizations. There are three categories: traditional charities, fee-for-service charities and support organizations. Charitable organizations not qualifying in one of these categories are private foundations. Exhibit 2  provides a list of the various types of public charities.

Private foundations are subdivided into two categoriesoperating and nonoperating foundations. Sec. 4942(j)(3) defines operating foundations and, thus, distinguishes between the two. While operating foundations spend most of their income directly for the active conduct of their exempt purpose, nonoperating foundations spend most of their income making grants to other charitable organizations. Often, private operating foundations are charities with too much investment income to qualify as public charities.⁴

Private nonoperating foundations are often family foundations, with exclusively investment assets that generate income for distribution as grants to public charities. The distinction is important for charitable giving purposes, because private operating foundations are 50% organizations, while private nonoperating foundations generally are 30% organizations.

An operating foundation has to make qualifying distributions of at least 85% of its income (or minimum investment income, if less) for the active conduct of its exempt purpose, and meet at least one of the following tests in Regs. Sec. 53.4942(b):

1. Assets test: The organization must devote at least 65% of its assets (valued at FMV) to its exempt purpose. Regs. Sec. 53.4942(b)-2(a)(2) defines assets used in the active conduct of the exempt organizations activities as real estate, physical facilities (e.g., equipment and fixtures), museum objects (e.g., artwork on display) and intangible assets (e.g., patents, copyrights and trademarks), as long as they are used directly in the active conduct of the exempt activity. Investment assets are not directly related to the active conduct, even if the income is used to conduct exempt activities.

2. Endowment test: The foundation normally must make qualifying distributions of at least two thirds of its minimum investment return, generally defined as 5% of the FMV of its investment assets.

3. Support test: The organization receives substantially all of its support (other than investment income) from the general public or five or more exempt organizations, and not more than one half of its support from investment income. In addition, not more than 25% may be received from any one exempt organization.⁵

Under Regs. Sec. 53.3942(b)-2, qualifying distributions are expenditures for charitable purposes or assets used for these purposes. These distributions also include payments to Sec. 501(c)(3) public charities and operating foundations, but not payments to organizations controlled by the foundation or disqualified persons. Payments to private nonoperating foundations are not qualifying distributions, unless the recipient organization makes an equivalent qualifying distribution by the end of the following year that is treated as a corpus distribution.

A private nonoperating foundation is generally a 30% organization. Under Regs. Sec. 1.170A-9(g), a nonoperating foundation is a 50% organization only if it distributes 100% of the contributions it receives during the tax year to qualifying public charities. This distribution must be made no later than two months and 15 days after year-end.

Example 3: A Foundation is a private nonoperating foundation. As of Jan. 1, 2004, it had no undistributed income for 2003. As income for 2004 is $250,000. During 2004, A receives $175,000 in individual contributions. To qualify as a 50% organization for 2004, A must distribute its income and total contributions received, or $425,000.

Qualifying distributions cannot be made to (1) an organization controlled by the foundation, (2) disqualified persons or (3) another nonoperating foundation. Because of these restrictions, most nonoperating foundations are 30% organizations in most years.

Why do individuals create private nonoperating foundations if the deductions for contributions to them are more restricted than those to public charities and operating foundations? First, it allows a donor to build up funds in a charitable organization that he or she controls. The donor can give 30% of AGI to his or her foundation every year, even if he or she has not decided which charity will be the ultimate beneficiary. In addition, the money donated to, and invested by, the private foundation will earn income at a very low tax rate. Under Sec. 4940, it is subject to a 2% penalty tax on net investment income, but is not subject to income tax.

Thus, a private nonoperating foundation is a good vehicle for taxpayers who want (1) the advantage of large tax deductions now, but want to defer deciding which charitable organization will ultimately receive donations; and (2) to make contributions to charities greater than their AGI limit. By accumulating funds in a private nonoperating foundation and the investment income from those funds, the taxpayer can build up substantial assets for distribution to his or her charity of choice.

The simplest rules are for cash donations to a 50% organization. For gifts by individuals, Sec. 170(b)(1)(A) limits these contributions, in the aggregate, to 50% of AGI. Similarly, cash gifts to a 30% organization are limited, in the aggregate, to 30% of AGI.

Generally, the deduction for contributions of capital gain property is the propertys FMV when donated. However, when an individual contributes a capital asset (e.g., land, securities or artwork) to a 50% organization, the deduction is generally limited to 30% of AGI. For this purpose, a capital asset includes Sec. 1231 business assets that, if sold by the donor, would result in long-term capital gain recognition (i.e., when Sec. 1231 gains exceed Sec. 1231 losses).

Example 4: In 2004, G makes a $40,000 contribution to his community hospital, a 50% charitable organization. His AGI is $120,000. This is the only charitable donation he makes this year. Gs charitable deduction is limited to 50% of AGI, or $60,000; thus, he can deduct the entire donation.

If, instead, G contributed appreciated securities with a $40,000 FMV and a $10,000 basis, the deduction would be limited to 30% of AGI or $36,000 ($120,000 x 30%), because the securities are appreciated capital gain property. G can carry forward the excess $4,000 nondeductible contribution and deduct it in a future year; the carryforward contribution retains its character as 30% property.

Despite the 30% AGI limit on gifts of appreciated securities, these gifts often provide greater tax benefits than cash gifts. For instance, in Example 4 above, not only does G receive a charitable deduction for the propertys FMV, he is also relieved of any income tax liability for the $30,000 stock appreciation. Thus, when a taxpayer has the choice, and AGI limits are not an issue, gifts of appreciated capital gain property often generate significantly greater tax benefits than cash gifts.

Private nonoperating foundations: There are special (and severe) limits on contributions of appreciated cap-ital gain property to private nonoperating foundations. Under Sec. 170(e)(1)(B)(ii), such donations must be reduced by the long-term capital gain that would have been recognized had the donor sold the property. This reduced amount is then limited to 20% of the taxpayers AGI. These rules substantially reduce the tax incentive to contribute appreciated capital gain property to private nonoperating foundations.

Example 5: Ls 2004 AGI is $150,000. She contributes land, with a $50,000 basis and an $85,000 FMV, that she has held as an investment for five years, to a private nonoperating foundation. This is her only charitable donation in 2004. Ls deduction is first reduced by the $35,000 of long-term capital gain that would have been recognized had she sold the property instead. The remaining $50,000 charitable deduction is further limited to 20% of AGI, or $30,000. L may carry forward the unused $20,000 and deduct it in a future year.

Qualified appreciated stock: There is some relief from the harsh treatment of donations of appreciated capital gain property to private nonoperating foundations. Contributions of "qualified appreciated stock" are deductible at FMV, unreduced by long-term capital gain. However, such contributions are still limited to 20% of the donors AGI.

Sec. 170(e)(5)(B) defines qualified appreciated stock as stock for which, as of the contribution date, market quotations are readily available on an established securities market. For example, in Todd,⁶ shares of stock in a bank holding company were transferred to a family foundation. The stock was not traded on a stock exchange or any national or regional over-the-counter market for which published quotations are available. In fact, there was no active market in the stock; shares were only available on those few occasions when a stockholder wanted to sell them. On only a few occasions over a 10-year period, a local brokerage firm acted as a placement agent to match buyers and sellers and provided a suggested share price based on the stocks net asset value.

The Tax Court found that market quotations were not readily available and, thus, the shares were not qualified appreciated stock. This reduced the potential charitable deduction by the stocks appreciationfrom $553,847 (FMV) to $33,338 (the taxpayers adjusted basis) (the deduction should have been reduced to zero, as will be discussed in Part II of this article). Clearly, it is critical that shares meet the requirements for qualified appreciated stock. Ideally, contributions to non-operating foundations should generally be in cash, for which the 30%-of-AGI limit applies, or qualified appreciated stock, limited to 20% of AGI.

As described above, the charitable deduction for appreciated capital gain property donated to a public charity is generally limited to 30% of AGI. Under Regs. Sec. 1.170A-8(d), however, a taxpayer can elect to reduce the contribution amount of such property by any long-term gain that would have resulted from a sale. The remaining charitable deduction is then subject to the 50%-of-AGI limit, rather than the 30% limit. This is of particular value to donors making donations of appreciated capital property that has a large value in relation to the taxpayers annual income, and when the propertys basis is relatively high.

Example 6: M and A are retired and live on an AGI of approximately $90,000 per year. They own a tract of land that produces no income, but has value for real estate development. M and A are attached to the land and want to contribute it to their community for development as a park. The city government has agreed to accept the property. M and A received the property several years ago from Ms fathers estate. The propertys basis is $300,000 and the appraised FMV is $425,000. The difference between the basis and FMV represents potential long-term capital gain if M and A were to sell the property.

If M and A contribute the property to the city and deduct its FMV, they would be allowed a deduction of $27,000 (30% of $90,000) in the donation year, and $27,000 in each of the five carryover years; the total deduction would be $162,000 (6 x $27,000). If M and As combined marginal Federal and state tax rate is 35%, they would realize a tax savings of $9,450 per year (35% x $27,000) for six years, for a total tax savings of $56,700 (6 x $9,450).

However, if M and A elect to deduct only their basis in the property ($300,000) as a charitable donation, they could deduct $45,000 per year (50% x $90,000) for six years. This would result in a tax savings of $15,750 per year (35% x $45,000), or $94,500 over six years (6 x $15,750). The overall tax savings would be $37,800 greater ($94,500 $56,700) than if they had not made the election.

If donated tangible personal property is put to an unrelated use, Sec. 170(e)(1)(B) requires reduction of the deduction by the long-term capital gain that would have been recognized had the property been sold. An unrelated use is any use unrelated to the charitable organizations exempt purpose. Tangible personal property is property other than real estate or intangible property (such as stock or debt securities) and would include contributions of art objects, jewelry, antiques, books, automobiles, yachts, etc.

Example 7: E donates a painting that she has held as an investment to a community hospital. The painting has a $36,000 basis and a $68,000 FMV. On receiving the donation, the hospital immediately sells the painting to an art dealer. The sale is an unrelated use; E is only eligible to deduct her basis.

If, instead, E had given the painting to an art museum, which put it on display for visitors, she would have received a $68,000 charitable deduction (the paintings FMV on the gift date) because the display is a related use.

The burden of determining whether property is put to an unrelated use is generally on the taxpayer. Regs. Sec. 1.170A-4(b)(3)(ii) provides, however, that the taxpayer may treat the property as though it were put to an appropriate related use if it was reasonable to assume that the property would not be put to an unrelated use at the time of the gift. However, the recipient charitable organization would be required to complete Form 8282, Donee Information Return, and submit it to the IRS if it disposed of the property within two years of receipt.

To prevent a reduced deduction due to a premature sale of tangible personal property contributed to a charity, the taxpayer should ask for a letter from the charity stating the propertys intended use.

If property donated to a charitable organization could have been sold to yield ordinary income or short-term capital gain, Sec. 170(e)(1)(A) requires that the propertys value be reduced by the ordinary income or short-term capital gain that would have arisen on sale. This limits the deductibility of contributions of ordinary income property, including:

• Inventory.

• Works of art, literary compositions, etc., given by the creator.

• Capital assets held one year or less. Thus, to maximize the charitable deduction, appreciated capital assets should be held more than a year before making a contribution to a charity.

• Business property subject to ordinary income recapture under Sec. 1245 or 1250.

Example 8: B is the sole proprietor of a bicycle shop. A local charity has asked B to contribute a bicycle to its annual benefit auction. B agrees to donate a bicycle with a $400 basis and a $750 net realizable value. Bs charitable deduction is limited to the $400 basis.

Example 9: The facts are the same as in Example 8. Bs bicycle shop also owns a copy machine used in the business for several years. The copier cost was $7,000; it is fully depreciated. B purchases a new copier and donates the old one to a local charity. The old copier has a $1,000 FMV. B receives no deduction from this contribution, because a sale of the old copier would have resulted in $1,000 of Sec. 1245 ordinary income recapture if sold at FMV.

    

Part II, in the June issue, will describe the ordering rules for taking deductions subject to the above limits, as well as planned-giving techniques, contributions of donated services and quid pro quo contributions.