Tuesday, November 13, 2012

Charitable Contributions and Tax Reform

As the federal government considers tax reform as part of a broader effort of improving its long-term budget crisis, charitable contributions have been one area of discussion.  The question seems to be whether the deduction afforded taxpayers who donate to charities is a “loophole” that should be removed from the tax code.  Being one of the larger deductions, it seems a natural target.  On the other hand, charities rely heavily on contributions, and these contributions are sure to decrease if the tax benefit is removed.  What surprises me is that there has not been a strong push for what I see as sensible middle ground – restrict the charitable deduction to cash donations.  Let me elaborate...
  • According to IRS figures, noncash donations to charities that are claimed as deductions on individual tax forms amount to around $50 billion each year.  A recent study by Ackerman and Auten (2011) in the National Tax Journal estimates that this accounts for $9 billion of lost tax revenue each year.  Depending on whether you ask the Democrats or Republicans, this amounts to somewhere in the range of 9-12% of new revenue goals.
  • Presumably, the reasoning behind the deductability of noncash donations is that (i) an individual uses his/her income to buy property; (ii) a charity may have a need for such property; and (iii) the individual donates the property to meet the charity’s need.  In such an exchange, the individual is effectively donating part of their income; hence, the deduction from income for determining taxes.  However, many donations of clothing, household goods, vehicles, etc. are to charities that have no need for them but simply sell them for cash.  While some restrictions have been put into place to limit overvaluation of such items by taxpayers, the fact that many charities are actively selling cars and boats on the secondary market would indicate the current arrangement is not ideal.  And, as noted by Ackerman and Auten (2011), enforcement of valuation rules is not simple.  Requiring donations be in the form of cash to be deductible, however, would simply entail them selling items first.
  • Moving beyond household items, the largest category of noncash donations is securities.  Again, there are some restrictions in place here, but the surprising thing is that the deduction for securities is for their fair-market value, even though the donor also does not need to realize a gain.  This means a donor who uses $10,000 of his/her earnings to buy stock that then appreciates in value to $25,000 can donate the stock to charity and deduct the entire $25,000 from income even though the income that led to this was only $10,000.  Thus, there is a strong incentive to donate securities so that the deduction from income actually exceeds the underlying income.  Common sense would stipulate that either the donor can only recognize a deduction for the original $10,000 (the only income recognized), or can claim the entire $25,000 deduction but must also at the same time recognize the $15,000 capital gain.  Perhaps making matters worse, some of these securities can be donated to donor advised funds or private foundations, meaning the value donated may not actually be put to use by a public charity until years after the deduction is claimed.  Requiring the security be converted to cash in order to recognize the deduction would seemingly better match the letter and spirit of the law.

Of course, there are downsides to any proposal, and I am not even claiming this is the right approach.  However, I am surprised it has not been discussed as a possible part of tax reform that may both raise revenues and shield charities from more crippling limitations on deductions.

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