Business & Economics
Charitable Trusts: Can Greed Ever Be Good?
The U.S. government uses incentives in its tax policy to promote charitable giving. Most people are aware that they can deduct donations that they make to charitable institutions from their taxes. For small amounts, some people may not take advantage of this. Others might prefer to send the money that they would owe in taxes to a favorite charity, which is more in tune with their values. As a result, they try to diminish their tax burden as much as possible in favor of donating to charity. But very wealthy individuals can take it to a whole new level.
One strategy to reduce your tax burden that you can use is the creation of your own charitable trust. Charitable trusts allow the wealthy to preserve their asset value by not paying capital gains taxes on assets they sell through the trust, deducting the value of the gift that was made from their personal income tax, and taking advantage of other tax benefits designed to encourage charitable giving.
The charity gets a taste and the donor, who otherwise might not have given to charity at all, is incentivized to give. So is this a situation where greed is morally good?
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Take a look at this video about one of the most popular kinds of charitable trusts that you can create, the charitable remainder trust. Assuming of course that you have a million dollars. It gives a simple explanation of how the process works but, more importantly, a glimpse into why the process works.
As you saw in the video, the fact that the beneficiary is a charity can be irrelevant. In fact, the commenter goes out of his way to explain that you don’t actually need to care about being charitable in order to take advantage of this setup. What you should care about is whether you and your spouse have a long life expectancy. Because if so you then will be able to get the maximum amount of utility out of your trust.
This is why the charitable remainder trust, and other ways that the government incentivizes charitable giving by providing tax benefits to donors, is thought of as a good idea. Not because it rewards people for giving to charity but because it incentivizes people who otherwise wouldn’t into donating as well.
People who are motivated by their conscience to give money to charity–particularly those who have an issue of critical importance to them and a charity that focuses on that issue–are going to give money anyway. They have a built-in incentive to do so and may even give whether they could claim a tax benefit from it. But those only make up a portion of donors all charitable donors in the United States. The other portion includes those who are pushed to donate to charity because they want the financial benefits that donating provides. Of course, there is likely some overlap, those who get satisfaction or social benefits as well as a tax deduction for their actions, but there is a subset for whom it is all about the money. And if they weren’t benefitting themselves they wouldn’t be giving to charity.
By providing a financial motivation to donate we are capturing a donor class for charities that we otherwise would not have. What we want is to maximize the donor pool and by appealing both to greed and to altruism we can get the most donors possible. So what is the problem here?
One problem that exists with this setup is the amount of benefit that charities actually receive. Incentivizing the wealthy to give to charity through greed may be a great idea–but only if those charities actually get the money–or enough money to justify our privileging a charitable donation over what government would collect in the form of taxes. People who want to take advantage of the tax benefits that we use to encourage charitable giving will often set up a private foundation, which will, in turn, donate money to various charitable endeavors. But the IRS only requires the private foundation to spend 5 percent of its assets annually. Further, it doesn’t require that 5 percent to go to the actual mission of the charity they are donating to, it can go to things like administrative costs.
The individuals setting up these private foundations are receiving very generous benefits in the form of a tax deduction, but the charities that are supposed to ultimately benefit from these foundations may not be.
The amount that each institution needs to spend to be considered charitable–5 percent–is an arbitrary number that does not really represent what is the best amount for these institutions to spend. Especially when that percentage is so small. And while foundations could spend more than the required 5 percent, they rarely do.
It might be a good idea to treat different types of charitable giving in different ways. For example, a donor who is setting up his or her own private foundation versus one who is giving to an already established one. Allowing a donor who creates their own charity to label that activity as “charitable” when it only needs to spend 5 percent of the gift on that purpose may be unfair. Whereas we may want to allow academic institutions managing large endowments to be fiscally conservative to preserve their resources. It may make sense for us to treat different types of foundations differently and not have a blanket 5 percent expenditure rule in order to qualify. What should be prioritized is the benefit received by the recipients of the foundation, not the potential benefits to a donor.
We also might want to take a look at just how good a deal a charitable remainder trust is for the donor and how good a deal it is for the charity. It isn’t a bad idea to incentivize charitable giving by appealing to greed–in fact, it may be a very good idea–but we can probably negotiate a better deal for the charities. In both the remainder trust and the lead trust, the charities receive a benefit but the donors arguably benefit the most. For example, with a charitable remainder trust, you can sell an asset, such as a stock, through the trust to avoid a capital gains tax. And then you can deduct from your taxes the value of the asset that you gave to the charitable trust. Over the term of the trust (which can be in years or for your or someone else’s lifespan) you receive payments from those assets. Whatever is left at the end of the term goes to the charity but the donor, if they were fortunate to live for a long time after its creation, may have taken the bulk of those assets in annuities in addition to the tax benefits they received for forming the trust in the first place.
The lead trust operates in the reverse, giving the charity annuity payments and then the remainder of the assets to the creator of the trust (or their heirs). But it is still a good deal for the donor, especially those of extreme wealth. In some cases, a lead trust can result in a profit beyond the initial tax deduction that will eventually go to its recipient.
Another concern with this incentive is: what qualifies as a charity? The definition of charity can go beyond what we might think of as traditional charitable pursuits such as clothing the naked or feeding the hungry. There seems to be a wide range of what can be included as a charitable activity, including groups that act primarily as political special interest groups.
How the Wealthy Use Charitable Trusts
The Koch brothers’ charitable giving provides a prime example of how a charitable trust can be used to protect generational wealth. In this case, the trust established by Fred Koch, the father of Charles and David, was a charitable lead trust. A charitable lead trust allows a donor to give money to the beneficiary tax-free as long as the interest that accrues on the original amount is donated to charity for a period–in this case 20 years. This allows the heirs to keep more of the fortune left for them while at the same time ensuring a steady stream of income charity. For the Koch brothers, the charitable trust is not only protecting generational wealth, it is also used to promote a specific political ideology. A tax subsidy for this may go beyond what most Americans are willing to support, which is one reason why these methods may be worth revisiting.
Another example of estate planning to protect generational wealth can be found in the Walton family, the heirs to the Walmart empire. The Waltons have used a variety of trusts, including charitable trusts, to avoid paying estate taxes on their wealth, thus preserving it in the Walton family for future generations.
The trust most famously used by the Waltons is the so-called “Jackie O Trust,” which is a charitable lead trust. For a family with a lot of wealth and a lot of time this can be a useful tool. For example, Helen Walton, Sam Walton’s wife, set up four trusts in 2003. When she set them up the IRS set a rate of 3.6 percent, which is based on the interest rates for U.S. Treasury bonds at the time the trust is formed and how much the trust is likely to go to charity versus the heirs. But because interest rates on U.S. Treasury bonds are so low–and they have been for a while now–investments into these trusts easily beat those rates. In fact, the trusts returned 14 percent a year from 2007 to 2011. Which means that the Waltons pay 3.6 percent of this money in estate taxes, but the extra 10.4 percent that the trust earned went back into the pile and eventually go to the Walton family. They are making more money for their future estates than they are giving away.
Charitable trusts have a worthy goal–to promote charitable giving–and use an effective strategy to try to achieve it. It is the kind of appeal to self-interest that the original federalists would have been proud of. One that acknowledges the dearth of altruism in human nature and makes the best of it. But the balance of funds given to the charity versus the financial benefit to the donor may not be sufficient to justify the loss of tax income to the government. The regulations on this kind of giving could do more to ensure that charities get a higher percentage of the gift and that the gift is specifically used for tangible charitable activities, not for administrative costs and salaries. Appealing to a wealthy family’s self-interest in order to promote charitable giving is smart. But it can and should be a better deal for charities than it is now to justify foregone tax revenue.
These regulations also could do more to define what qualifies as a charity in the first place. Political discourse is a worthy goal in and of itself. But it may not be one that Americans want their government to promote through a tax incentive. Or, if we decide it is, then that should be separate from the promotion of charitable contributions. We can be careful about how money that we allow to go to charity rather than to government projects is being spent by taking another look at what we define as charitable. The rules for what is charitable are murky–donations to a 501(c)3 that engages in “education” are deductible, while a donation to a 501(c)4 that engages in politics is not, but the line between the two is not clearly defined. The requirements for the kinds of donations that we want to allow exemptions for should be clearer and more stringent.
If we are going to siphon tax dollars away from important government functions, through charitable tax deductions, the charities that are eligible should be ones that do charitable work that is similar to those goals. That way individuals who don’t want their taxes to support policy X but have no problem with policy Y can give to a charity that does something similar to policy Y. They are still incentivized to give but lost government revenue should not be done in vain.