After changes were made to the federal tax law, more precisely to itemized deductions, at the end of 2017, many nonprofits have been left wondering how tax reform will impact charitable donations received and individuals are trying to determine how to maximize their tax benefit from donations.
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law. TCJA is the biggest tax reform that Congress has enacted in over 30 years and made significant changes to the tax law for both individuals and businesses. Some of the most significant changes for individuals revolve around itemized deductions and the increase in the standard deduction.
Impact of Changes to Standard and Itemized Deductions
Each tax year individuals are allowed to reduce their Adjusted Gross Income by the greater of their itemized deductions (i.e. state and local taxes, mortgage interest expense, charitable contributions, etc.) or the standard deduction. TCJA nearly doubled the standard deduction starting in 2018 – $12,000 for single filers; $24,000 for married filing joint; $18,000 for head of household. At the same time TCJA made changes to the itemized deductions that may limit these deductions for some individuals, particularly the $10,000 cap on total state and local taxes.
The combination of these changes will mean that some individuals that had previously itemized deductions will now be taking the standard deduction. The Tax Policy Center is projecting that about 11% of households will be itemizing deductions on their individual tax return under the new tax law, which is down from approximately 26% under prior law.
This means that one of the potential side effects under the tax reform is that some individuals may choose to reduce donations to charities because they are no longer receiving a tax benefit. The Joint Committee on Taxation estimates that individuals may reduce charitable giving by $13 billion annually as a result of this tax law change.
“Bunching” as a Strategy to Receive Tax Benefits from Charitable Donations
With proper tax planning some individuals may be able to continue receiving a tax benefit for the donations they make. One way to achieve the maximum tax benefit from charitable donations is through a technique called “bunching.” An individual that uses this technique will combine and make multiple years of normal annual charitable donations in a single year in order to increase the likelihood that itemized deductions will exceed the standard deduction and provide additional tax savings.
Let’s look at the following example to put this into perspective: Betty is a single filer and she typically donates $3,000 per year to a favorite local charity. Her other annual itemized deductions (state and local income taxes, real estate taxes and mortgage interest expense) total $8,000. Without bunching donations, Betty’s itemized deductions ($11,000) would be lower than her $12,000 standard deduction so she would take the standard deduction each year. If Betty were to bunch three years’ worth of annual donations ($9,000) into Year 1 her itemized deductions would be $17,000 which exceed the standard deduction in Year 1 by $5,000 resulting in a tax benefit for the donations. Then in Years 2 and 3, Betty would reduce her donations to a lower level and would take the standard deduction for these years.
Donor-Advised Funds as a Method of Receiving Tax Benefits from Donations
Another method for achieving this same result is through the use of a donor-advised fund (DAF). The DAF has been around since the 1930’s and has grown in popularity starting in the 1990’s with a large increase within the last year. A DAF is essentially a charitable savings account that allows donors to make a charitable donation, receive an immediate tax deduction and then recommend grants from the fund over time. Various public charities, including most major financial institutions, provide the opportunity for donors to setup a DAF with an initial contribution to the fund. This initial contribution can vary based upon the firm administering the DAF but can be as low as $5,000. An individual can contribute cash or other assets, such as stock, to the DAF where it can be invested and grow tax free. At any time the individual may direct funds to be granted from the account to their favorite qualified charity.
Using the previous example, in Year 1 Betty could establish a donor-advised fund and decide to contribute the $9,000 (three years of annual donations) in order to receive the immediate tax deduction in Year 1 even if she only distributes $3,000 to the local charity through the DAF in the first year. In Years 2 and 3, Betty could continue to distribute $3,000 from the DAF in order to even out her donations to the local charity while still receiving the tax benefit in Year 1.
There are a lot of factors to consider when making this type of decision and not everyone’s facts and circumstances are the same. We strongly encourage you to discuss tax planning opportunities such as “bunching” and DAFs with your tax advisor in order to determine if these strategies will benefit you. If interested in donor-advised funds we also encourage you to discuss with your financial or investment advisor for complete details.
ABOUT THE AUTHOR
Matt is a Senior Tax Manager with Brown Schultz Sheridan & Fritz and a key member of the Firm’s Tax Department. Matt has over ten years of experience servicing closely held and family-owned businesses in numerous industries, including craft beverage, manufacturing, distribution and construction/real estate.