July 01, 2013

Doing Well by Doing Good: How Senior Lawyers Can Maximize the Tax Benefits of Their Charitable Contributions

Bruce A. Mann

Senior lawyers and their clients frequently have their peak earning years as they near retirement. Many have accumulated sufficient wealth for their retirement and want to provide ongoing support for charities they have been involved with during their working years. I interviewed Peter K. Maier, a professor emeritus of Hastings College of the Law, University of California, San Francisco, on the subject of how to do so in the most tax-efficient manner and how to use charitable contributions to ameliorate the tax consequences of a year in which a lawyer has exceptionally high income. Peter has taught at UCLA, Stanford Law School, and Boalt Hall, the UC Berkeley School of Law. He is also a registered investment advisor and chairman of Private Wealth Partners, LLC, a Marin County investment management firm.

Mann: Let me start with a situation that arises occasionally, Peter. Suppose an attorney receives in one year an extraordinarily large fee which is not likely to occur regularly in the future. What can he or she do in the way of a charitable contribution to offset the very substantial tax liability which would otherwise obtain?

Maier: Well first, Bruce, we need to note that as of January 1, 2013, federal taxes on ordinary income were raised substantially for those taxpayers earning $250,000 a year or more in salaries, dividends, interest, rents, and other forms of ordinary income. And in some states, particularly California, rates also increased substantially for higher-income taxpayers. One should also note that the taxes imposed by the Affordable Care Act (“Obamacare”) added an additional level of taxation starting in 2013. Therefore, your question has more tax import this year than it would have had in the prior 10 years.As far as offsetting the fee is concerned, obviously the attorney can make a cash charitable gift to any 501(c)(3) organization and, subject to certain percentage limits, deduct it from his or her income for tax purposes. That would normally be true for the state tax as well. However, making that donation in cash is a relatively expensive method of reducing one’s taxable income as compared to alternatives that are available.

Mann: Please describe some of those alternatives.

Maier: One of the most basic is not to make the contribution in cash but in appreciated property, such as investment assets. This would normally include stocks, bonds, real estate, and the like. It could also be a personally owned asset, as, say, a residence or a car. If the asset would have resulted in a long-term capital gain if it had been sold instead of donated, then the donor will receive a deduction equal to the fair market value of the property on the date of the gift.

Mann: Why is it important that the asset be taxed as the long-term capital gain if sold?

Maier: Because Section 170(e) of the [Internal Revenue] Code provides that if that is not the case, i.e., if the sale of the asset would have resulted in ordinary income, then only the basis (tax cost) and not the fair market value will be the amount of the deduction.

Mann: Are there other limitations a taxpayer should be aware of?

Maier: Yes. In the case of tangible personal property, the Internal Revenue Code imposes a requirement that the donated asset be used for the charitable purposes of the donee. An example would be a gift of appreciated wine donated to a charity. If the property will be used as an auction item, only its cost could be deducted, since it is, in effect, being sold. On the other hand, if the wine were served at a dinner for donors or the faculty, the fair market value should be deductible. Another example is a painting donated to a museum, which would probably be deductible at its full fair market value; but if given to the SPCA [Society for the Prevention of Cruelty to Animals], presumably only the cost would be available, unless of course the painting were of a horse or a dog and the SPCA would display it on its premises. So this is not a really difficult technical requirement.

Mann: Are there other limitations about which we should be concerned?

Maier: Yes. First of all there is a limit of 30 percent of appreciated property given to a charity, with the balance being carried over to the following year to be deducted in future tax returns. However, a donor can give an additional 20 percent in cash if he or she wants and deduct it that year. There is therefore an overall limitation of 50 percent, if any of our fellow lawyers are that charitable. And the rules are more restrictive if the gift is to a private foundation, as opposed to a public charity.

Mann: Is there anything else that we should be aware of?

Maier: Yes. It is certainly worth repeating once again that the holding period for capital assets is not one year, but more than one year. I have seen instances in which a donor waited to give highly appreciated property to a charity until it was exactly one year old, which resulted in a deduction of only the cost and not the market value.

Mann: Are there other assets about which one should be concerned with respect to charitable donations?

Maier: Yes, there are other items that would be taxed as ordinary income even if they were held for more than one year, such as stock in trade, or inventory held for sale to customers in the ordinary course of business. So, if a store donated some of its merchandise for sale to a charity instead of selling it, it could only deduct the cost, not the fair market value. Other examples are more technical: they involve recapture of depreciation on tangible personal property and real property which, if sold, would be partially taxable as ordinary income. For example, donating a partially depreciated law library to the local bar association would result in some depreciation recapture.

Mann: How does that work?

Maier: Say an attorney has used his or her car for business and depreciated it fully and now donates it to a charitable organization with the expectation of receiving a fair market value deduction. That will not happen, because if the car had been sold, the sales price would have been taxed entirely as ordinary income under Section 1245 of the Code. Therefore, giving the car away will not produce any deduction in this situation.

Mann: Would the attorney be better off to sell the car and donate the proceeds?

Maier: No; the results would be the same. The proceeds of the sale would be taxed as ordinary income and the donation would be deducted, offsetting it and again netting zero.

Mann: Getting back to my original question, are there provisions in the Code to provide some relief to an individual who receives an extraordinarily high payment in one year, such as spreading it over a period of years to reduce the tax rates?

Maier: Historically, we had provisions in the income tax law which allowed income averaging, so that in the situation you posed of an attorney receiving, say, a $1 million fee in one year and substantially less in prior years, he or she could average the income as if it had been earned over the prior years. Unfortunately, that provision was repealed several years ago and no longer exists.

However, one can achieve that result to some extent contractually if the situation is anticipated in advance. This is accomplished through a deferred compensation agreement, by the terms of which the attorney provides in a contract with the client that, in the event the fee exceeds a certain amount, it will be paid over a specified number of years.

Mann: Are there any disadvantages to such an arrangement?

Maier: Yes. The lawyer has to be an unsecured general creditor of the client, so you are taking a chance on whether you get paid in those future years. If you trust your client and he or she is creditworthy, the arrangement would probably work out well, but one does take that chance in such an arrangement. Incidentally, these kinds of agreements are quite common in the entertainment and sporting industries, where actors or athletes who have extraordinarily high earnings for a few years spread those earnings out over a period of many years to avoid very high tax rates in the year in which they are earned. That is a legal arrangement. A lawyer who agrees to represent a client in a potentially large contingent fee case might consider entering this type of fee arrangement in his engagement letter.

Mann: If the attorney did not anticipate that result, could the arrangement be retroactively agreed on, i.e., after the personal injury judgment is awarded?

Maier: No. At that point the lawyer’s fee has been earned and is payable and will be taxed in full when received.

Mann: Let’s get back to the gift to charity. Assuming that the amount of the gift is within the percentage limitations specified in the Code, are there other vehicles available to offset the taxable income?

Maier: Yes. The lawyer could set up a charitable remainder trust, by the terms of which he or she receives an income for a specified period of time, and after that period ends, the charity receives the property. That income interest could be for a specified number of years, but more commonly is for the lifetime of the donor, and possibly for additional beneficiaries, such as the spouse or the children.

Mann: Could you use the award itself for the charitable remainder gift?

Maier: Yes, but the deduction would only partially offset the amount of the earned fee. Specifically, it would be the value of the charitable remainder after the donor’s intervening life estate(s).

Mann: Can you give us an illustration of how that would work?

Maier: Yes. Say an attorney gives cash or highly appreciated property to a charity for a remainder trust and retains the life interest for his and his spouse’s lifetime, remainder to the 501(c)(3) charitable organization. The annuity tables provided by the IRS specify both parties’ life expectancy. Assume the value of the lifetime interest is, say, 50 percent and the remainder is 50 percent. So if the attorney establishes a charitable remainder trust for $100,000, he would receive a $50,000 deduction and would have a $50,000 basis in the charitable annuity. This would be recovered ratably over the expected period of time that the donors live.

Mann: Are you saying that the government knows how long we are going to live?

Maier: In a sense, yes. They have annuity tables that specify to several decimal points what the average life expectancy would be of a man, a woman, a couple, or even a family, and the presumption is conclusive that the donors will live that period of time.

Mann: What happens if they live longer than the tables assume?

Maier: After the annuitants have recovered their investment in the contract (cost), then any remaining payments will be taxable in full. Conversely, if they die earlier than the annuity tables assume, there is a loss deduction that can be taken on the decedent’s final tax return for the difference. This methodology therefore translates the annuity tables (which are averages) to the particular annuitants’ situation.

Mann: Is it possible to use appreciated stock or other property to establish a charitable remainder trust?

Maier: Absolutely. That works somewhat better than giving cash, because part of the capital gain inherent in the property is postponed for long periods of time, i.e., the term of the annuity or annuities. So, if the attorney and the spouse had a joint and survivor annuity and they had a 20-year life expectancy, the capital gain would be taxed over a period of 20 years.

Mann: Any other tax benefit?

Maier: Certainly; the value of the charitable remainder would be deductible in full in the year of the donation.

Mann: Are there devices available to a donor for a charitable deduction other than those you mentioned?

Maier: Yes. The lawyer might consider a charitable lead trust, which is the converse of the charitable remainder trust. Instead of receiving an income for life and then relinquishing the property at death, donors provide an income interest for a charity during their lifetimes or a fixed number of years, remainder to the noncharitable beneficiaries, such as members of their family.

Mann: Why would you want to do that?

Maier: Well, if the donor were wealthy enough that he or she did not need the income, a charitable lead trust provides an immediate deduction for the value of the income interest (also determined under the annuity tables). When that period ends, the beneficiaries receive the asset with a reduced or no gift or estate tax.

Mann: Has that been as widely used as a charitable remainder trust?

Maier: No, because relatively few taxpayers are in the situation where they can forgo the income for a period of years or for their lifetime. Also, the fact that the new estate and gift tax exemptions are now at $5 million plus annual cost-of-living increases ($5.25 million in 2013), one can pass a lot of assets free of gift and estate taxes to the non-spousal members of the family, or others, without incurring a transfer tax. So this would only apply to relatively very wealthy donors.

Mann: You mentioned “non-spousal”; why?

Maier: Because an individual can give or bequeath as much money or property to his or her spouse without paying any federal estate or gift tax, irrespective of the amount.

Mann: Can you give us an illustration of how that works?

Maier: Sure. William Gates Sr., a retired lawyer and prominent philanthropist, was an early investor in the company started by his son, Bill Gates, the chairman and founder of Microsoft. He could give or bequeath many millions of dollars to his spouse during his lifetime or by will—there would be no gift or estate tax on the transfer.

Mann: But then Mrs. Gates would have to pay the tax when she sold the stock?

Maier: Only if she sold it during his lifetime. If the stock were community property—which in the case of Washington State is the fact—then on the death of Mr. Gates Sr., his assets are “stepped up” to their fair market value under the provisions of Section 1014(b)(6) of the Code. So Mrs. Gates could, after his demise, sell all of his stock for cash and pay no income tax on the profit, unless the state of Washington has other laws different from those of the federal ones.

Mann: Would any portion of this huge transfer be taxed at any point?

Maier: In this example, only when the donee—Mrs. Gates in this example—dies, the proceeds of the sale of the stock (i.e., the cash) would be taxed in her estate at its value at that time. That is, unless she remarried and left the stock to her spouse, in which case it would be further postponed.

Mann: Does this have any implication for those of us who are not as wealthy as Mr. Gates?

Maier: Yes. A simple example would be a common practice of giving your principal residence to your children to get them out of your estate under a so-called QPRT [qualified personal residence trust]. If the donor outlives the periods specified in the QPRT, the asset is excludable from the estate.

Mann: So this is a good thing to do to minimize our estates?

Maier: Usually not any more. As I mentioned before, the estate tax exemption is now over $5 million, and it is likely to go up over the years, so most attorneys, and if they are married, they and their spouses, can bequeath to others $10.5 million without incurring an estate tax. This assumes they have not used up part of their exemption in their lifetime(s). If one’s assets are worth less than that amount, there is no point in transferring any assets out of one’s estate, and there is an advantage in keeping them there, namely, the stepped-up basis I mentioned before. In the case of a community property spouse, if one of them dies, then Section 1014(b)(6) of the Code specifies that the entire asset is stepped up and the survivor can sell the appreciated family home, and for that matter all other appreciated assets, at the fair market value at the death of the first spouse. In the case of separate property states, it is only the deceased spouse’s own property that is stepped up.

Mann: Are there other things an attorney might consider doing to ameliorate the “tax bite” of an extraordinarily high fee earned in one year?

Maier: Yes. There are always different forms of retirement plans. The lawyer’s practice could be incorporated, which I think is now legal everywhere, and the corporation can adopt a pension or profit-sharing plan to which contributions are deductible and which accumulates income tax free until those assets are withdrawn, usually at retirement. That would certainly offset a part of his or her income for the year. A less fancy alternative are Keogh plans, Individual Retirement Accounts, and 401(k) plans for self-retired persons. These are all widely used, but the rules and regulations relating to these different types of plans are detailed and have to be followed to the letter, and are, I think, beyond the scope of our discussion today.

Mann: Let’s change the assumption, Peter, and consider the case of an attorney who has been consistently receiving high fees. Given the new higher tax rates of which you spoke, are there other devices that he or she could use to reduce taxable income?

Maier: Yes. If the attorney has been consistently successful, he or she has, hopefully, saved or invested a portion of that income. It would be possible to set up a trust for the benefit of his or her children or another dependent, such as an aged parent, and to shift the taxability of that item from the attorney’s tax return to the trust for the benefit of the donee. To make this tax-effective, there is a requirement that the children be over age 14; otherwise the income from the trust is taxed at the parents’ tax rate—this so-called “kiddy tax.” But, as you are aware, one’s obligation to financially support children and other relatives does not end at age 14, so it would be possible to set up trusts to pay for many other expenses. The only exception is expenses for the support of a child, which, if legally obligated, are again taxed to the parent.

There is a minor disadvantage in establishing an irrevocable trust for such a beneficiary, namely, that a portion of the donor’s gift tax exemption will be used. The portion that is subject to transfer tax is the fair market value on the date of the gift (i.e., the date the trust is created) of the income or remainder interest given to the child, parent, etc. But, considering the new $10.5 million exemption for a married couple, this gift tax consideration becomes substantially less important for most persons than it would have been when the exemption for gift and estate tax purposes was only $1 million.

Mann: Would the trust assets be includable in the donor’s estate?

Maier: Yes, as to part of them, namely the remainder interest retained by the parent-donor. That amount would be based on the valuation of the asset that reverts to the donor when the trust ends. Finally, there are some provisions requiring the donor to give up control over the assets while they are in trust. For example, he or she could not decide which of the children-beneficiaries would receive the income and could not borrow the trust assets without adequate security; nor could he or she retain an income for a period of time that does not end until the donor’s death. These are technical provisions which should be drafted by an attorney specializing in gift and estate planning or by a tax attorney.

Mann: What about outright gifts to children and others?

Maier: If they are truly outright, i.e., the donor retains no control over the donee’s gift, this would be excludable from the donor’s estate if he or she had no financial interest in the trust and had an independent trustee. There is also a requirement that at least three years elapse between the date of the gift and the donor’s date of death to assure that the gift would be excludable.

Mann: Could the independent trustee be one of the donor’s law partners?

Maier: Theoretically, yes, if he or she can make decisions independent of the donor’s wishes.

Mann: What about so-called tax shelters as a way to reduce an attorney’s taxable income?

Maier: They went out of style quite a few years ago. Congress passed a series of laws designed to preclude an individual offsetting his or her earned income (whether from law practice or otherwise) by “investing” in partnerships or joint ventures that from the beginning were designed to lose money for tax purposes. The details are complicated, but there are some vestiges of tax sheltering which are still allowed.

Mann: What are those, Peter?

Maier: Two that are clearly still legal and accepted by the IRS are investing in oil and gas ventures, which can produce percentage depletion deductions, and investing in other assets used in a trade or business or held for investment, which are depreciable. For example, an attorney can invest in an office, apartment, or warehouse building and depreciate (write off) the portion applicable to the building (as opposed to the land) over the expected useful life of that property. This does not depend on demonstrating that the asset is in fact depreciating in value. On the contrary, in the past, our experience has been that while the value is going up, its tax cost is going down. That continues to be a very favorable method of reducing one’s income.

Mann: Thank you, Peter, for focusing today on ways high-net-worth individuals can benefit charitable institutions as they reduce their tax liability.

Maier: You’re welcome.

Bruce A. Mann

Bruce A. Mann (bmann@mofo.com) is a senior partner at Morrison and Foerster; he is based in its San Francisco office, where he practices corporate and securities law. Mr. Mann has held numerous leadership positions in the ABA. He has been, for example, chair of the Senior Lawyers Division and of several ABA Business Law Section committees, including the Federal Regulation of Securities Committee, Private Equity and Venture Capital Committee, International Technical Assistance Committee, Membership Committee, and Emerging Issues Task Force. His current positions include those of chair of the Senior Lawyers Division’s Investment Strategies Committee and Nominating Committee, vice-chair of its Ethics & Professionalism Committee, and Experience editorial board member.