The problem with most tax planning is that you have to give up something to get something. To get an income tax deduction you must spend a dollar to save taxation on a dollar. To get a deduction for a business expense, you must incur a business expense. To get a personal deduction you must pay a deductible expense.
Income taxes are not at a 100% rate thankfully, so one normally thinks wisely before spending a dollar to save tax on a dollar, usually about 40% (35% federal plus state tax). Then if you save the dollar long enough your estate may become so large that it has to pay an estate tax of almost 50% (currently 47%). Let’s not forget FICA and Medicare, both sides being around 15%. Phew, it’s no wonder why most people loathe the IRS and tax time.
So what can you do to feel better about tax time? Outside of not paying taxes, which will land you in hot water with the IRS, and possibly in jail, you can set up something that will help reduce your taxable income and help you do good at the same time. That something is a private charitable foundation. This is a type of structure that you can create, or more realistically have your tax lawyer create for you. With a private charitable foundation you can transfer different types of property into the foundation, such as stock, cash, bonds, real estate, and other assets, and receive an income tax deduction today for transferring assets into your foundation. You’ll not incur capital gains tax, and avoid estate tax not only on the transfer but on any appreciation on the assets as well!
How does it work?
A private foundation or even better a private operating foundation (because you can contribute a larger percentage of your annual income to it) is an exempt entity formed in accordance with IRC Â§501(c)(3), which is the section that governs charitable entities. A private foundation is a privately funded and controlled entity that makes distributions to various charities. A public charity, on the other hand, is publicly supported.
To create a private foundation, you need to create an entity within a state or United States Possession as a not-for-profit entity (usually a corporation). This creates an entity that is not for profit on the state level as well as the federal level. You must file a Form 1023, Application for Recognition of Exemption with the Internal Revenue Service Center in Covington, Kentucky.
Usually you have 12 months, which can be extended, to file the application after you’ve created the state recognized entity. If for some reason you are not successful, you do have the right to appeal an adverse decision. The IRS determinations are retroactive to the date you began the entity when timely filed.
After you have received your letter of determination, you are tax exempt!
That means you can now transfer property from yourself, to your private foundation and receive an income tax deduction, within limits, for your transfers. Any assets transferred to it at your passing are also excluded from estate tax! The growth of any invested assets is also tax exempt, and excluded from your taxable estate.
All charities, public and private, prior to 1969 have had limitations on how large of an income tax deduction you can take for charitable contributions. Before 1969 there was an unlimited deduction, and you could, in essence, eliminate all income tax if you were so charitably inclined. The current
limitations for charitable deductions are based upon a percentage of your adjusted gross income as follows:
Fifty Percent Limitation
This is the maximum limitation that is available for all contributions to public charities, and private operating foundations.
Thirty Percent Limitation
This limitation applies to contributions to semipublic charities, private foundations, and to contributions “for the use of” any charitable organization.
Twenty Percent Limitation
This limitation applies to contributions of appreciated property to semi-public charities and to private foundations.
There is also an offset against 3% of your adjusted gross income after it exceeds a certain level. ($142,700 married filing joint, $71,350 if married filing separately).
Presume you had adjusted gross income of $1,000,00 and projected itemized deductions of $100,000. You are married and have no dependents. Your projected federal income tax without making a charitable deduction is $319,900.
Now let’s presume you have excess funds that you will transfer to your private charitable foundation. You transfer $175,000 to the foundation. Your new projected income tax is $254,100. The $175,000 that was in a money market fund may now be in the same institution in a new money market fund, which your private foundation manages.
The result: You have reduced your projected federal income tax by $65,800. You still have the funds to manage, and you have also reduced your taxable estate by the full transfer.
What’s the catch?
You must distribute at least 5% of the funds in the foundation every year to your favorite charitable cause! So if you earn less than 5%, you will eat into the principal to make the 5% gift to another charity. If you earn more than 5% you can retain it in the foundation.
If you normally give money to charitable causes, houses of worship and other endeavors, and you have a phenomenal income year, you can contribute to your foundation, take your tax deduction today, and use the funds for an indefinite time period to make charitable distributions in the future.
You can even have the charity pay you money every year if you want current income, with the remainder to go to named charities! Of course, as I said at the beginning of this article you have to give something up to get something. You can get a stream of income for life, but you have to take a smaller current charitable deduction to achieve this. Payment of compensation (or the payment or
reimbursement of expenses) can be made to the creator of the foundation, family members or others performing services for the foundation. However, compensation is taxable to the party receiving the funds; payments for reimbursements of business expenses from the foundation are tax-free, however. Still, a private foundation is a nice way to use excess property, from the standpoint of tax deductions and supporting your favorite causes.
The charitable entity you structure may also be an outlet to transfer rapidly appreciating stock and avoiding capital gains on the sale. It could be a means to diversify your portfolio without incurring tax. Best of all, with all the worthy causes that are ought there, the horrible natural disasters and funds needed, you can do your part to help society and help yourself to tax savings!
Who says the whole tax code is bad?
Copyright Inc.com, 375 Lexington Avenue, New York, NY 10017.
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.