Dispelling Some of the Income Tax Myths of Charitable Planning
By Christopher R. Williams, Principal, Personal Financial Services,
Ernst & Young LLP
The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.
- Will I receive a benefit from my charitable contributions if I am in the Alternative Minimum Tax (AMT)?
- Will a charitable contribution make me subject to the AMT?
- Will I still receive a tax deduction for my charitable contribution if I have more taxable income this year?
- Isn't there a phase out of itemized deductions as my income increases?
These are some of the most common questions regarding charitable planning tax professionals receive from clients. This article will help dispel some of the most common income tax myths related to charitable contributions.
Myth #1 – If a taxpayer is subject to the AMT, they will not receive an income tax deduction for charitable contributions made.
The AMT can be a daunting and complex subject. But with the AMT impacting more and more taxpayers each year it is important to understand the basic principles of the AMT and how a taxpayer's charitable planning may be impacted by the AMT.
History of the Alternative Minimum Tax (AMT)
The AMT was enacted in 1969 to make sure that the wealthiest taxpayers paid a minimum amount of tax, and were not taking advantage of too many tax benefits. The AMT is a parallel tax system, and each year taxpayers need to calculate their taxes under both the AMT and the regular tax system. First, taxpayers calculate their tax liability under the regular tax system by adding up all of their income and then taking deductions for items such as property taxes, state income taxes, mortgage interest, and charitable contributions. Then taxpayers must calculate their tax liability under the AMT system. The taxpayer then compares the two tax calculations and pays the higher of the two taxes. For most taxpayers from 1969-2001 the regular tax system usually resulted in higher taxes. However, with The Economic Growth and Tax Relief Reconciliation Act of 2001, the regular tax rates decreased to a level where more people became subject to the AMT tax system.
Impact of the AMT — Generally
So what does it mean if you are in the AMT? There a number of issues, but here are the most significant ones to consider. First, the good news - the AMT has a maximum rate of only 28 percent. That is lower than the 35 percent maximum rate for ordinary income taxes. Second, the bad news is that the 28 percent rate may be applied to a larger taxable income number. Why? Because the AMT takes away a number of tax benefits granted under the regular tax system. The most common itemized deductions that are not deductible under the AMT are as follows:
- State and local income taxes
- Real estate taxes
- Home mortgage interest (if the loan was not used to buy, build, or improve a home)
- Miscellaneous itemized deductions (e.g., investment advisory fees, and tax preparation fees)
Impact of the AMT on Charitable Contributions
If you look back at the list above, you will notice that charitable contributions are not one of the deductions lost when a person is subject to the AMT. As a result many AMT taxpayers will still receive a tax savings when they make charitable contributions. Even though they receive a tax benefit in the current year, taxpayers should still consult with their tax advisor to see if making the contribution in a future year might make more sense. Why? Because if the taxpayer will be out of the AMT in a future year, it might make sense to defer the contribution. Let's take a look at two examples.
- Example 1: Catherine Grace is considering making a $100,000 charitable contribution. In working with her tax advisor she calculates that she will be subject to the AMT in both 2007 and 2008. Assuming she is in the highest AMT tax bracket, her maximum rate is 28 percent. So whether she makes the contribution this year or next, she will reduce her income taxes by $28,000 (28 percent x $100,000).
- Example 2: Jack White is considering making the same $100,000 charitable contribution. In working with his tax advisor he calculates that he will be subject to the AMT in 2007 and the regular tax system in 2008. Assuming he is in the highest AMT tax bracket, his maximum rate is 28 percent. Assuming he is in the highest ordinary tax bracket in 2008, his maximum rate will be 35 percent. So if he makes the contribution this year he will reduce his income taxes by $28,000 (28 percent x $100,000). If he makes the contribution next year, he will reduce his income taxes by $35,000 (35 percent x $100,000), or $7,000 more.
Example 1 shows us that for taxpayers who are charitably inclined, and who will be chronically subject to the AMT year after year, it generally makes sense for them to make the contribution in the current year. However, in Example 2 we see that even though a taxpayer may receive a tax benefit when they are subject to the AMT, they might consider deferring the contribution to a year when they are out of the AMT to receive a larger tax benefit.
Myth #2 – Making a large charitable contribution will make a taxpayer subject to the AMT.
Many taxpayers are under the impression that if they have a large number of deductions they will be subject to the AMT. That is true to a point. Only if the taxpayer has a larger number of certain types of deductions (e.g., property taxes, state income taxes) will they be more easily thrown into the AMT. Because the charitable contribution deduction is allowed for both the regular tax system and the AMT, many times it will not throw the taxpayer into the AMT. As a general rule, the higher the taxpayer's Adjusted Gross Income (AGI), the less likely it is that the charitable contribution will put them into the AMT. Let's look at an example:
- Example 3: Paul and Debbie Jones are a married couple with no children. They currently have $500,000 of AGI and have $24,000 of state income tax and property tax deductions. They are considering making a $30,000 charitable contribution this year. Without the charitable contribution, their regular income tax liability would be higher than their AMT liability. With the charitable contributions, both their regular tax liability and the AMT liability would both be reduced, but the regular tax liability would still be higher. In this case they would not be subject to the AMT. However, if Paul and Debbie increased their charitable contribution to over $55,000, they would still receive a benefit for the charitable contribution, but they would start to become subject to the AMT.
As a taxpayer's AGI increases even higher (e.g., more than $1 million) this becomes less and less of an issue because their regular tax liability is significantly higher than their AMT tax liability. As a result it can become increasingly less likely that the charitable contribution will put these very high income taxpayers into the AMT.
Myth #3 – If you are not subject to the AMT and are a high income taxpayer you will definitely lose some of your charitable contribution deduction because of the phase out of itemized deductions.
Is this myth actually true? Isn't there a phase-out of itemized deductions when a taxpayer's income gets too high? Here is the answer:
- If the taxpayer lives in a state with an income tax rate of 2 percent or higher, they will generally receive the full benefit of their charitable contribution deduction, even if their income is very high.
- If the taxpayer lives in a state with an income tax of less than 2 percent, they may start to lose the benefit of the charitable contributions (as well as other deductions such as mortgage interest and property taxes).
Many people cannot see how this can be true, but let's walk through two examples.
- Example 4: Ron DeCoco has an AGI this year of $700,000. This is a typical income year for Ron. Ron is married, lives in Connecticut (which has a 5 percent state income tax), pays $15,000 in property taxes, and normally gives $20,000 a year to charity. High income taxpayers (those who's AGI exceeds $156,400 per year (married filing jointly)) will lose some of their itemized deductions at a rate of 2 percent of the amount their income exceeds the phase out threshold. So in this example Ron will lose close to $11,000 of his itemized deductions (($700,000 - $156,400) x 2%).
- Example 5: The same facts as above, except that now Ron is considering exercising a stock option which will generate another $500,000 of AGI. Because of the additional income he is considering making an additional $200,000 charitable contribution this year. Should he make the extra contribution? Won't he lose the benefit of the contribution because of the phase out of itemized deductions? In this case, he will get the full benefit of the charitable contribution. Why?
- As his income increases by $500,000, he will lose an additional $10,000 of itemized deductions.
- But as his income increased, what has also increased? His state income taxes. The $500,000 of income will result in an additional $25,000 state income tax.
- This state income tax is almost like a mandatory deduction that has the effect of canceling out the phase out of the itemized deduction.
- As a result, if Ron now gives an additional $200,000 to charity, he will receive the full $200,000 deduction.
It should not just be assumed that the phase out of the itemized deductions will limit a taxpayer's ability to receive the full benefit from the charitable contributions. In our example, because the taxpayer lived in a state with a 5 percent income tax and takes this "mandatory" deduction, the phase out of itemized deductions did not limit the charitable deduction. The answer would be different if the taxpayer lived in a zero-income-tax state (e.g., Florida, Texas, or Washington), because there the state income tax would not be available to offset the impact of the phase out.
Hopefully, what we have illustrated is that these common myths do not universally apply to all taxpayers. The question of whether they apply or not depends on the taxpayer's unique facts and circumstances. Taxpayers and their advisors should not rely on rules of thumb, but should instead "crunch the numbers" to see what makes the most sense for their charitable giving plan.
Pursuant to IRS Circular 230, please be advised that, to the extent this communication contains any tax advice, it is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of avoiding penalties under U.S. federal tax law.