In the dead of night, again breaking its pledge to allow at least 72 hours for the public to review proposed legislation prior to a vote, the House of Representatives passed legislation to temporarily avert the "fiscal cliff." Among provisions found within the American Taxpayer Relief Act of 2012 is one raising concerns within the charitable sector. Like a vampire (only worse, given vampires have the courtesy to stay dead if properly staked), a section of the Internal Revenue Code (IRC) first operative during the George H. W. Bush administration, but (un)successfully "staked" during the George W. Bush administration, has risen from the grave.
Colloquially known as the Pease provision after a Congressman who championed the idea, the provision, Section 68 of the IRC, eliminates a portion of itemized deduction for certain high income taxpayers. Since the deduction for charitable gifts is an itemized deduction, the charitable sector’s concern is understandable. However, a close review of the provision’s mechanics reveals most taxpayers’ itemized deductions attributable to charitable gifts will not be reduced as a result of the limitation. Indeed, this should be true even in the case of significant charitable gifts.
The American Taxpayer Relief Act of 2012 resurrects Section 68 of the Internal Revenue Code (IRC) for taxable years beginning after December 31, 2012. Section 68 of the IRC limits allowable itemized deductions of certain high income taxpayers. Taxpayers subject to the phase-out are those with adjusted gross income (AGI) greater than $300,000 if married filing a joint return, greater than $250,000 if filing as single, $275,000 if filing as head of household, or, in general, $150,000 if married filing a separate return. Section 68 defines these amounts as the "applicable amount."
The statute reduces a taxpayer’s otherwise allowable itemized deductions by three percent of the amount the taxpayer’s AGI exceeds the applicable amount that applies given their filing status. The itemized deduction phase-out can never exceed 80 percent of a taxpayer’s otherwise allowable itemized deductions (i.e., the phase-out is the lesser of three percent of the excess of a taxpayer’s AGI over the applicable amount or 80 percent of the otherwise allowable itemized deductions).
Example 1: Taxpayer files as single, has an AGI of $1 million and $600,000 of itemized deductions before phase-out. Taxpayer’s itemized deduction phase-out is $22,500. (Adjusted gross income of $1 million minus $250,000 applicable amount for a taxpayer filing as single equals $750,000 times .03 equals $22,500, which is less than the $480,000 maximum phase-out [allowable itemized deductions of $600,000 before phase-out times .80 maximum phase-out percentage equals $80,000].)
Although on its face Section 68 reduces the otherwise allowable itemized deduction for charitable contributions, Examples 2 and 3 illustrate why few donors lose the tax benefit of charitable gifts as a result of the itemized deduction phase-out.
Example 2: Same facts as found in Example 1, except consider the fact that Taxpayer’s itemized deductions consist of $100,000 paid for state income and real estate taxes and $500,000 attributable to charitable gifts. Given this fact pattern, it is safe to say none of the $500,000 itemized deduction attributable to charitable gifts was lost as a result of the itemized deduction phase-out.
If Taxpayer made no charitable gifts, itemized deductions pre-phase-out are $100,000. After phase-out, allowable itemized deductions are $77,500.00 (total itemized deductions, $100,000, less $22,500 phase-out equals $77,500 of allowable itemized deductions).
One hundred percent of the $77,500 allowable itemized deductions are attributable to costs Taxpayer could not (at least legally) avoid -- income and real estate taxes. Should Taxpayer choose to make a $500,000 cash charitable gift to a public charity during the tax year, Taxpayer increases their allowable itemized deductions to $577,500.00. No additional itemized deduction phase-out occurs as a result of Taxpayer’s voluntary decision to make the charitable gift. The full benefit of the itemized deduction attributable to the charitable gift, $500,000.00, is obtained.
A final example illustrates the minimal impact the itemized deduction phase-out has on most charitable taxpayers.
Example 3. Assume the same facts as in Examples 1 and 2, except Taxpayer makes $3 million of charitable gifts rather than $500,000.00. The result in the tax year of the charitable gift is identical to that in Example 2. Although Taxpayer made a $3,000,000 charitable cash gift, rather than $500,000.00, otherwise allowable itemized deductions remain at $600,000.00 for the year, prior to phase-out. This results because of the 50 percent AGI limitation on cash gifts to public charities (i.e., Taxpayer’s allowable deduction for cash gifts to public charities before the itemized deduction phase-out is $500,000.00 -- 50% of Taxpayer’s $1 million AGI). The remaining $2.5 million itemized deduction for charitable gifts is carried over and useable during the subsequent 5 tax years, subject to application of the same limitation rules (and ignoring possible future changes to the tax law). Assuming a similar fact pattern as in the tax year of the charitable gift during the 5 subsequent tax years, the charitable deduction carryover will be fully allowed (since other itemized deductions should be viewed as subject to phase-out prior to phase-out of the itemized deduction for charitable giving, as illustrated in Example 2).
As illustrated, most charitable taxpayers -- including those making gifts exceeding the AGI limitations for current year deductibility -- will see the full tax benefit from their charitable gifts irrespective of the itemized deduction phase-out. There is an exception to this. Those taxpayers who have few, if any, "mandatory" payments generating itemized deductions may lose some of the tax benefit from their charitable gifts. However, even taxpayers residing in low rate (or no) income tax states may very well have significant "mandatory" itemized deductions for items such as real estate taxes and mortgage interest that should be considered as subject to phase-out before the "voluntary" itemized deduction attributable to charitable gifts is ever phased out.