Gifting Unique Assets: Philanthropy and Tax Planning

The following information and opinions are provided courtesy of Wells Fargo Bank N.A. Wealth Planning Update Gifting Unique Assets: Philanthropy and Tax Planning JULY 2014 Erika Mielke Senior Wealth Planning Strategist Meghan Oldis Senior Wealth Planner Audrey Truman Senior Trust and Fiduciary Specialist Philanthropic Services In this Wealth Planning Update:» The Taxpayer Relief Act of 2012 shifted investors focus from estate planning to managing income tax» Gifting of unique assets to charity may be an effective strategy to fulfill philanthropic endeavors while managing tax liability» With a variety of asset types available and unique requirements for each, careful consideration is warranted prior to any gift When the Taxpayer Relief Act of 2012 was passed on January 1, 2013, you could almost hear a collective sigh of relief as the federal estate tax exemption was permanently set at $5,000,000 per person, indexed annually for inflation, and portable between spouses. But by the time the sun set on January 2, it became apparent that the law s estate tax simplification was matched toe to toe by increasing complexity in the income tax rules. Suddenly taxpayers were asked to track and understand the differences between taxable income, adjusted gross income, modified adjusted gross income, and the varied implications of each. It soon became clear that the days of estimating income tax liability on the back of an envelope were long gone. In one fell swoop, estate tax planning became much less of a concern, while income tax planning moved front and center for everyone. As if the complexity of the income tax code were not enough, individual portfolio complexity also continues to change. Today savvy investors don t necessarily stop with traditional assets, they also maintain a diverse portfolio of unique assets. Those unique assets may include art, real estate, life insurance policies, closely held companies or intellectual property. When unique assets are on the balance sheet, it can become as much of an art as it is a science to manage the juxtaposition of net worth with cash flow. So what is a taxsensitive diversified investor to do? Some investors may find refuge in an interesting spin on a familiar strategy by exploring charitable gifting with those unique assets. Despite the growing complexity of the income tax code, charitable giving is still incented through deductions against taxable income and unique assets could potentially present an opportunity to manage tax exposure. Each type of asset comes with a variety of considerations, but with an 1

understanding of these factors, unique assets may prove both a more effective gift for the organization and a more efficient gift for the donor. Unique asset #1: Art Many individuals spend a lifetime collecting beautiful works of art to adorn their home. Art collectors tend to beget more art collectors as they inspire the same love of beauty in their children. So what happens when the art collector determines it is time to downsize to a home with less gallery wall space? If their children already have collections of their own or perhaps don t have the same taste as mom and dad, it can be a difficult process to find a loving new home for treasured art. If art work held by a collector is donated to a charitable organization that will display it in a manner consistent with its exempt purposes, the donor may be eligible receive a deduction equal to the fair market value of the piece. If the gift qualifies for a fair market value deduction, the donor should obtain a qualified appraisal by a professional appraiser of art work, unless the art donations are worth $5,000 or less. If a donor gifts several pieces and the aggregate donation amounts to $20,000, a qualified appraisal will be required. If the charity sells, exchanges or otherwise disposes of the work in the year of the contribution, the donor s deduction will be limited to cost basis. Even if the charity does not dispose of the piece but their gift acceptance policy gives them the right to do so, the donor s deduction may still be limited to cost basis. In the unique situation where the donor is the artist that created the piece being donated, the tax deduction is confined to the basis of the art. As with all things timing is key. A donor may have a highly valuable piece to give but be unable to take advantage of the entire deduction in one year due to income limitations. In that instance, a donor may want to consider a strategy that would structure the gift over multiple years, giving a partial interest each year until the gift is complete, or use the five-year deduction carryover to capture the deduction over time. An additional strategy called a bargain sale allows the donor to sell the piece at for a discounted price and receive a deduction equal to the difference between the sale price and the piece s fair market value. Unique asset #2: Real estate Real estate can be a great asset for a donor to gift. Often times, a donor will consider giving property if they are looking to simplify their balance sheet and manage cash flow. Real estate may or may not provide an income stream but it always produces expenses. As long as the donor held the property for more than a year, the donor can receive a deduction equal to the fair market value of the property. However, if the real estate has depreciated in value, the recapture rules may reduce the amount of the deduction. In the hands of the charity, the property could be sold without capital gain consequence and the charity would potentially recoup the full value of the property. If the organization keeps the property for use in accordance with its exempt purpose, it could benefit from property tax exemption. As with gifts of artwork, a donor gifting real estate could structure the gift over a period of years to maximize the full impact of the charitable deduction. This would, however, require strategic planning regarding the payment of expenses on the property during the period when the donor and charity find themselves owning the real estate together. A simpler approach may be to use the five- year carryover of 2

any unused deduction to future tax years. A donor could also negotiate a bargain sale when transferring real estate to charity. A commonly used technique for donors who wish to realize some cash flow from the sale of real estate while potentially minimizing capital gains taxes, eliminating estate tax consequences, and fulfilling a charitable intent is to place the real estate asset in a charitable remainder trust. If there are concerns about the real estate asset not being able to meet the requirement of paying out a stream of income from a charitable remainder trust, a flip charitable remainder trust may help fill the gap. With trusts like these, the sale of the property will flip a switch in the charitable remainder trust, providing a tax advantaged income stream to the donor or other non-charitable beneficiary for a period of time as detailed in the trust. At the end of the trust s term, the remaining trust assets will be distributed to the charity. Unique asset #3: Life insurance Life insurance can be a great asset in a well-coordinated wealth plan and it can also be a great way to leverage your charitable giving. Many people have life insurance, but they may not be reviewing their insurance policies as often as they should. As a result, people may have policies hanging around on their balance sheets that were appropriate when they bought them, but just don t fit into their wealth plan today. You can always cash in an old policy but that might trigger unwanted income tax consequences. Instead, you may want to consider giving that policy to a charitable organization. The donor will receive a deduction equal to the lesser of the cost basis in the policy or the interpolated terminal reserve a fancy term that refers to the policy s fair market value as calculated by the insurance carrier. If there are premiums due on the policy, either the charity must be willing to pick those up or the donor may make additional annual cash gifts to cover the premium and then take the corresponding annual deductions. A variation on that theme for donors who want to hedge their bets is to name the charity as a beneficiary of their insurance policies while maintaining ownership. These donors would not receive an income tax deduction since they still own the policy, along with the right to change the beneficiary, but the donors estate would receive the deduction at the donors death. If you don t have extra life insurance policies sitting around, you can still leverage your giving and partner with a charity to create a new charity-owned policy. With this structure, the donor makes a cash gift to the charity so the organization can purchase a policy. The policy could be structured for a single premium funded by that initial cash gift or the donor could pledge additional premiums as annual gifts to the charity and take the corresponding annual deductions. However, when going this route, the insurance underwriters will likely want to see proof of the donor s giving history to the charity as assurance those successive premiums will be paid. Unique asset #4: Shares of a closely held business Managing cash flow and taxes can be an intricately choreographed dance when a closely held business is on the balance sheet. There are effective ways for business owners to offset taxes through charitable giving without throwing their cash flow out of whack. 3

Owners of closely held corporations can work with charitable organizations to give shares of the company to the charity and receive a deduction equal to the fair market value of the stock contributed. This can be especially beneficial when the owners of the company are beginning to contemplate a sale or liquidation of the company. It may result in tax savings, while providing cash flow for the charity and the business owner. Generally speaking, closely held businesses have strict rules around permitted shareholders and may have issues with an outsider who is not related to the family or the other shareholders owning a piece of the business. In that case, the company can redeem the charity s stock at fair market value once the gift is completed. However, this technique can be tricky. Any stock redemption by the company cannot be a prearranged requirement of the gift. If it is, the donor s sale of the stock will be treated as such and contributing the proceeds will trigger a tax on the gain followed by a deduction. If redemption of the stock is impractical, the donor may consider using a charitable remainder trust instead. In this case, the donor contributes stock to the trust, maintaining control over it until it is sold. When the company is eventually sold, the donor s capital gain liability on the contributed stock is mitigated, the donor or other non-charitable beneficiary receives an income stream for a period of years as defined by the trust, and at the end of the trust term the charity receives the remainder. Alternatively, if the business owner would prefer to transfer the company to the next generation, the new incoming business owners may be able to contribute shares to a charitable lead trust. The charity would receive an income stream from the stock during the term of the trust. The donor is able to maintain greater control over the contributed stock and may reduce or eliminate gift or estate tax, while passing the asset in trust to heirs. Unique asset #5: Intellectual property We live in a technological society that is moving at the speed of light. As a result, some firms are finding themselves in possession of patents, copyrights, trademarks, trade secrets, and other similar property they may no longer need. Rather than see this innovation go to waste, firms are finding ways to donate intellectual property to charitable organizations at an increasing rate. When intellectual property is gifted, the donor must relinquish all rights to the use and ownership of the property in order to receive a deduction. While the donor may be giving up the technology, the donor is also controlling competitors access to the rights. For example, a technology firm could gift a patent to a university allowing its researchers and students to use the patent in their scientific study. Or a software developer could give a charity an important program that helps them further its stated mission. For the gift to be deductible, the donor must transfer all substantial rights in the intellectual property to the charity. The deduction will then be limited to the lesser of the donor s basis in the contributed property or its fair market value. If the donor contributes the property to a charity other than a private foundation, the donor may be able to claim a second deduction. With a gift as potentially intangible as intellectual property, it can be difficult to determine fair market value. New regulations were passed in 2004 governing their valuation; please contact your legal and tax advisor to determine your potential deduction. 4

Gifting Unique Assets to Charity Asset Type Potential Deduction Considerations Art Fair Market Value (FMV) deduction if donated to charity that displays in a manner consistent with exempt purposes Real Estate Life Insurance Closely Held Business Intellectual Property FMV deduction if held more than one year Deduction is lesser of cost basis or the policy s FMV Deduction equal to FMV of stock Deduction limited to lesser of donor s basis or FMV Cost basis deduction if charity disposes of piece in year of contribution. If the donated asset is a highly valuable piece, you may not be able to take the entire deduction in one year. You may be able to structure over multiple years, use fiveyear carryover or bargain sale. If depreciated, recapture rules may reduce amount of deduction. May not be able to take entire deduction in one year so can structure over multiple years, use five-year carryover rule, bargain sale or place in a Charitable Remainder Trust. If premiums are due, must be paid by the charity or donor makes additional cash gifts. May name charity as beneficiary. Donor s estate receives deduction at donor s death. If no existing policy, may partner with charity to create a charity-owned policy. Rules may restrict who may qualify as a shareholder. May donate stock to Charitable Remainder Trust or Charitable Lead Trust, depending on how business is organized (C Corp, S Corp, or LLC). Must transfer all substantial rights. Can be difficult to determine FMV. When gifting assets to a charity, it is key to determine what the charity s gift acceptance policy allows. Some charities may not accept certain assets that do not align with their mission or these assets may create a burden for them. Diverse balance sheets offer different options for you to try and meet your charitable goals. Sometimes the road is straight and flat, and other times it meanders around bends and over rivers. But if you are working with well-coordinated, holistic-minded advisors who are able to survey the entire landscape, you can arrive at your destination safe and sound. As Melinda French Gates said, Helping people doesn t have to be an unsound financial strategy. Disclosures Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries. Wells Fargo affiliates may be paid a referral fee in relation to clients referred to Wells Fargo Bank, N.A. Wells Fargo Bank, N.A. (the Bank ) offers various advisory and fiduciary products and services. Financial Advisors of Wells Fargo Advisors may refer clients to the bank for an ongoing or one-time fee. The role of the Financial Advisor with respect to bank products and services is limited to referral and relationship management services. The Bank is responsible for the day-to-day management of non-brokerage accounts and for providing investment advice, investment management services and wealth management services to clients. The Financial Advisor does not provide 5

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